Standard Deviation

Keat and Young (2006) note that uncertainty may result in a wide variety of potential outcomes. A probability distribution describes the chances of various outcomes occurring by plotting a probability for each outcome. Quantitative risk analysis can yield the probabilityweighted average of all the outcomes on the curve itself. This is termed expected value (EV, or eNPV). Keat and Young (2006) note that the idea is for management to look at variations from EV in order to make decisions. For example, management may want to decide which projects may result in greater cash flow. Let us explore how banks like mine use this analysis to for much more than budgeting. In particular, they use it to prepare for potential losses. Standard deviation is a bell-curve that reflects the relative distance that outcomes have from the EV. A tighter (less wide) bell indicates that probabilities are not widely dispersed from the EV. We intuitively understand that there is less uncertainty if outcome probabilities are close to the EV. If we imagine a greater dispersion of outcome probabilities from the EV (a wider-bell curve), we intuitively understand that there is greater uncertainty (risk) because potential outcomes have wide variations from what is expected. For example, the EV for losses due to a cyber-breach at a bank may be $500,000. However there may also be some outcomes where losses exceed tens of millions of dollars. Wide dispersions of outcomes (regardless of probability) cause management to worry about specific events that can cripple the firm. Dowd (2005) notes that investors observe the standard deviation (variance) of returns on a

portfolio of investments that they own. The standard deviation represents risk to the portfolio. We intuitively understand that investors want a portfolio whose return has a high EV and low standard deviation from that EV. Portfolio Theory (PT) attempts to measure the standard deviation of the returns that assets in a portfolio are likely to yield. However calculating PT is difficult for a variety of reasons. Therefore many financial institutions (including mine) use a Value At Risk (VAR) models to answer the root question: What is the worst that can happen? VAR determines the maximum loss management should expect for a portfolio of holdings with, say, 95% confidence. Linsmeier and Pearson (1996) note that VAR is important for boardroom decision makers and regulators who want to know the magnitude of potential losses on the portfolio. A major limitation is that VAR models often provide widely varying estimates of losses because of the ways in which the models are implemented and the assumptions they make. Taleb (1997) notes that firms may be worse off relying on misleading VAR calculations than on not having any information at all. Another limitation of VAR is that it is the equivalent of telling someone the expected number of deaths on a regular commercial flight: While it may be good to know that there is a 95% chance that only .02 people are expected to die on a flight, we might be worried about what is beyond that 95%. Specifically, in the case of a crash how many are expected to die? Expected Tail Loss (ETL) is also known as Expected Shortfall (ES). ETL or ES is a progression of VAR that tells us the expected loss (i.e. how many people are expected to die) in that unlikely 5% tail of the normal distribution curve.

References Keat, P., & Young, P (2006). Managerial Economics. Linsmeier, T., & Pearson, N (1996). Risk Measurement: An Introduction to Value at Risk. Retrieved from www.exinfm.com/training/pdfiles/valueatrisk.pdf. Dowd, Kevin (2002). An Introduction to Market Risk Measurement. Geer, David (2006). Measuring Project Risk. Retrieved from www.computerworld.com.au/article/147911/measuring_project_risk.