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Part of the overall calculation of uncertainty according to RiskMetrics recommendations, however, should include a calculation of correlative uncertainty (Finger 2007). The rationale for including this specific uncertainty in calculations is that it helps to account for inaccuracies and inadequacies in the model, determining the level of risk associated with incorrectly defined or changing correlations used by the model in other calculations and definitions (Finger 2007). An accurate calculation of uncertainty and risk will necessarily include a calculation of the correlative uncertainties attendant upon the model and the situation to which it is applied, providing not a necessarily more accurate view of direct risk, but a useful evaluation of the risk prediction's efficacy.
RiskMetrics Calculations: Exposure and Uncertainty
An accurate and well-developed combined understanding of the exposure and uncertainty of a various investment venture or portfolio contributes a nearly complete understanding and assessment of the risks presented by that investment option/portfolio. There is a complex interaction between exposure of cash assets and continuing cash flow and other uncertainties that are facing the company(ies) that make up a given investment or portfolio, and exposure to macroeconomic forces as well as market forces must be considered when attempting to calculate the level of uncertainty inherent to certain levels of exposure in specific instances (Andren et al. 2005). The greater the level of knowledge regarding these forces and their movements, and the effects of these forces on cash flow in a given industry -- i.e. The more effective, current, and accurate the risk analysis model is that is being utilized...
2005). Calculating exposure risks must therefore take into account the market and macroeconomic uncertainties, as opposed to most current methods that assess cash flow and credit exposure from an analysis and calculation of potential market shifts and market-risk exposures only (Andren et al. 2005).
In order to calculate both the uncertainties and exposures facing a given investment/portfolio, identifying the market risks as well as the macroeconomic forces at play is a necessity, with cash flow trends playing a prominent role in identifying both exposures and uncertainties that face the company(ies) in question (Andren et al. 2005). The Monte Carlo method allows for the greatest flexibility in defining variables and in sampling, and with adequate information supplied in the creation of the model this would provide reliable risk calculations based on uncertainties and exposures.
References
Andren, N.; Jankensgard, H. & Oxelheim, L. (2005). "Exposure-Based Cash-Flow-At-Risk under Macroeconomic Uncertainty." Journal of applied corporate finance 17(3), pp. 21-31.
Argentin, P. (2010). "Two-sided counterparty risk." RiskMetrics Group: On the Whiteboard. Accessed 24 September 2010. http://www.riskmetrics.com/on_the_whiteboard/20100615
Finger, C. (2007). "We identify two main versions of correlation risk -- parameter uncertainty and new financial products -- and examine the modeling challenges implied by each." RiskMetrics Group: Research Monthly. Accessed 24 September 2010. http://www.riskmetrics.com/publications/research_monthly/20070400
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