Risk Metrics Calculation

Calculate portfolio risk metrics including VaR, CVaR, Sharpe, Sortino, and drawdown analysis. Use when measuring portfolio risk, implementing risk limits, or building risk monitoring systems.

Comprehensive risk measurement toolkit for portfolio management, including Value at Risk, Expected Shortfall, and drawdown analysis.

When to Use This Skill

• Measuring portfolio risk
• Implementing risk limits
• Building risk dashboards
• Calculating risk-adjusted returns
• Setting position sizes
• Regulatory reporting

Core Concepts

1. Risk Metric Categories

Category	Metrics	Use Case
Volatility	Std Dev, Beta	General risk
Tail Risk	VaR, CVaR	Extreme losses
Drawdown	Max DD, Calmar	Capital preservation
Risk-Adjusted	Sharpe, Sortino	Performance

2. Time Horizons

text

Intraday:   Minute/hourly VaR for day traders
Daily:      Standard risk reporting
Weekly:     Rebalancing decisions
Monthly:    Performance attribution
Annual:     Strategic allocation

Implementation

Pattern 1: Core Risk Metrics

python

import numpy as np
import pandas as pd
from scipy import stats
from typing import Dict, Optional, Tuple

class RiskMetrics:
    """Core risk metric calculations."""

    def __init__(self, returns: pd.Series, rf_rate: float = 0.02):
        """
        Args:
            returns: Series of periodic returns
            rf_rate: Annual risk-free rate
        """
        self.returns = returns
        self.rf_rate = rf_rate
        self.ann_factor = 252  # Trading days per year

    # Volatility Metrics
    def volatility(self, annualized: bool = True) -> float:
        """Standard deviation of returns."""
        vol = self.returns.std()
        if annualized:
            vol *= np.sqrt(self.ann_factor)
        return vol

    def downside_deviation(self, threshold: float = 0, annualized: bool = True) -> float:
        """Standard deviation of returns below threshold."""
        downside = self.returns[self.returns < threshold]
        if len(downside) == 0:
            return 0.0
        dd = downside.std()
        if annualized:
            dd *= np.sqrt(self.ann_factor)
        return dd

    def beta(self, market_returns: pd.Series) -> float:
        """Beta relative to market."""
        aligned = pd.concat([self.returns, market_returns], axis=1).dropna()
        if len(aligned) < 2:
            return np.nan
        cov = np.cov(aligned.iloc[:, 0], aligned.iloc[:, 1])
        return cov[0, 1] / cov[1, 1] if cov[1, 1] != 0 else 0

    # Value at Risk
    def var_historical(self, confidence: float = 0.95) -> float:
        """Historical VaR at confidence level."""
        return -np.percentile(self.returns, (1 - confidence) * 100)

    def var_parametric(self, confidence: float = 0.95) -> float:
        """Parametric VaR assuming normal distribution."""
        z_score = stats.norm.ppf(confidence)
        return self.returns.mean() - z_score * self.returns.std()

    def var_cornish_fisher(self, confidence: float = 0.95) -> float:
        """VaR with Cornish-Fisher expansion for non-normality."""
        z = stats.norm.ppf(confidence)
        s = stats.skew(self.returns)  # Skewness
        k = stats.kurtosis(self.returns)  # Excess kurtosis

        # Cornish-Fisher expansion
        z_cf = (z + (z**2 - 1) * s / 6 +
                (z**3 - 3*z) * k / 24 -
                (2*z**3 - 5*z) * s**2 / 36)

        return -(self.returns.mean() + z_cf * self.returns.std())

    # Conditional VaR (Expected Shortfall)
    def cvar(self, confidence: float = 0.95) -> float:
        """Expected Shortfall / CVaR / Average VaR."""
        var = self.var_historical(confidence)
        return -self.returns[self.returns <= -var].mean()

    # Drawdown Analysis
    def drawdowns(self) -> pd.Series:
        """Calculate drawdown series."""
        cumulative = (1 + self.returns).cumprod()
        running_max = cumulative.cummax()
        return (cumulative - running_max) / running_max

    def max_drawdown(self) -> float:
        """Maximum drawdown."""
        return self.drawdowns().min()

    def avg_drawdown(self) -> float:
        """Average drawdown."""
        dd = self.drawdowns()
        return dd[dd < 0].mean() if (dd < 0).any() else 0

    def drawdown_duration(self) -> Dict[str, int]:
        """Drawdown duration statistics."""
        dd = self.drawdowns()
        in_drawdown = dd < 0

        # Find drawdown periods
        drawdown_starts = in_drawdown & ~in_drawdown.shift(1).fillna(False)
        drawdown_ends = ~in_drawdown & in_drawdown.shift(1).fillna(False)

        durations = []
        current_duration = 0

        for i in range(len(dd)):
            if in_drawdown.iloc[i]:
                current_duration += 1
            elif current_duration > 0:
                durations.append(current_duration)
                current_duration = 0

        if current_duration > 0:
            durations.append(current_duration)

        return {
            "max_duration": max(durations) if durations else 0,
            "avg_duration": np.mean(durations) if durations else 0,
            "current_duration": current_duration
        }

    # Risk-Adjusted Returns
    def sharpe_ratio(self) -> float:
        """Annualized Sharpe ratio."""
        excess_return = self.returns.mean() * self.ann_factor - self.rf_rate
        vol = self.volatility(annualized=True)
        return excess_return / vol if vol > 0 else 0

    def sortino_ratio(self) -> float:
        """Sortino ratio using downside deviation."""
        excess_return = self.returns.mean() * self.ann_factor - self.rf_rate
        dd = self.downside_deviation(threshold=0, annualized=True)
        return excess_return / dd if dd > 0 else 0

    def calmar_ratio(self) -> float:
        """Calmar ratio (return / max drawdown)."""
        annual_return = (1 + self.returns).prod() ** (self.ann_factor / len(self.returns)) - 1
        max_dd = abs(self.max_drawdown())
        return annual_return / max_dd if max_dd > 0 else 0

    def omega_ratio(self, threshold: float = 0) -> float:
        """Omega ratio."""
        returns_above = self.returns[self.returns > threshold] - threshold
        returns_below = threshold - self.returns[self.returns <= threshold]

        if returns_below.sum() == 0:
            return np.inf

        return returns_above.sum() / returns_below.sum()

    # Information Ratio
    def information_ratio(self, benchmark_returns: pd.Series) -> float:
        """Information ratio vs benchmark."""
        active_returns = self.returns - benchmark_returns
        tracking_error = active_returns.std() * np.sqrt(self.ann_factor)
        active_return = active_returns.mean() * self.ann_factor
        return active_return / tracking_error if tracking_error > 0 else 0

    # Summary
    def summary(self) -> Dict[str, float]:
        """Generate comprehensive risk summary."""
        dd_stats = self.drawdown_duration()

        return {
            # Returns
            "total_return": (1 + self.returns).prod() - 1,
            "annual_return": (1 + self.returns).prod() ** (self.ann_factor / len(self.returns)) - 1,

            # Volatility
            "annual_volatility": self.volatility(),
            "downside_deviation": self.downside_deviation(),

            # VaR & CVaR
            "var_95_historical": self.var_historical(0.95),
            "var_99_historical": self.var_historical(0.99),
            "cvar_95": self.cvar(0.95),

            # Drawdowns
            "max_drawdown": self.max_drawdown(),
            "avg_drawdown": self.avg_drawdown(),
            "max_drawdown_duration": dd_stats["max_duration"],

            # Risk-Adjusted
            "sharpe_ratio": self.sharpe_ratio(),
            "sortino_ratio": self.sortino_ratio(),
            "calmar_ratio": self.calmar_ratio(),
            "omega_ratio": self.omega_ratio(),

            # Distribution
            "skewness": stats.skew(self.returns),
            "kurtosis": stats.kurtosis(self.returns),
        }

Pattern 2: Portfolio Risk

python

class PortfolioRisk:
    """Portfolio-level risk calculations."""

    def __init__(
        self,
        returns: pd.DataFrame,
        weights: Optional[pd.Series] = None
    ):
        """
        Args:
            returns: DataFrame with asset returns (columns = assets)
            weights: Portfolio weights (default: equal weight)
        """
        self.returns = returns
        self.weights = weights if weights is not None else \
            pd.Series(1/len(returns.columns), index=returns.columns)
        self.ann_factor = 252

    def portfolio_return(self) -> float:
        """Weighted portfolio return."""
        return (self.returns @ self.weights).mean() * self.ann_factor

    def portfolio_volatility(self) -> float:
        """Portfolio volatility."""
        cov_matrix = self.returns.cov() * self.ann_factor
        port_var = self.weights @ cov_matrix @ self.weights
        return np.sqrt(port_var)

    def marginal_risk_contribution(self) -> pd.Series:
        """Marginal contribution to risk by asset."""
        cov_matrix = self.returns.cov() * self.ann_factor
        port_vol = self.portfolio_volatility()

        # Marginal contribution
        mrc = (cov_matrix @ self.weights) / port_vol
        return mrc

    def component_risk(self) -> pd.Series:
        """Component contribution to total risk."""
        mrc = self.marginal_risk_contribution()
        return self.weights * mrc

    def risk_parity_weights(self, target_vol: float = None) -> pd.Series:
        """Calculate risk parity weights."""
        from scipy.optimize import minimize

        n = len(self.returns.columns)
        cov_matrix = self.returns.cov() * self.ann_factor

        def risk_budget_objective(weights):
            port_vol = np.sqrt(weights @ cov_matrix @ weights)
            mrc = (cov_matrix @ weights) / port_vol
            rc = weights * mrc
            target_rc = port_vol / n  # Equal risk contribution
            return np.sum((rc - target_rc) ** 2)

        constraints = [
            {"type": "eq", "fun": lambda w: np.sum(w) - 1},  # Weights sum to 1
        ]
        bounds = [(0.01, 1.0) for _ in range(n)]  # Min 1%, max 100%
        x0 = np.array([1/n] * n)

        result = minimize(
            risk_budget_objective,
            x0,
            method="SLSQP",
            bounds=bounds,
            constraints=constraints
        )

        return pd.Series(result.x, index=self.returns.columns)

    def correlation_matrix(self) -> pd.DataFrame:
        """Asset correlation matrix."""
        return self.returns.corr()

    def diversification_ratio(self) -> float:
        """Diversification ratio (higher = more diversified)."""
        asset_vols = self.returns.std() * np.sqrt(self.ann_factor)
        weighted_vol = (self.weights * asset_vols).sum()
        port_vol = self.portfolio_volatility()
        return weighted_vol / port_vol if port_vol > 0 else 1

    def tracking_error(self, benchmark_returns: pd.Series) -> float:
        """Tracking error vs benchmark."""
        port_returns = self.returns @ self.weights
        active_returns = port_returns - benchmark_returns
        return active_returns.std() * np.sqrt(self.ann_factor)

    def conditional_correlation(
        self,
        threshold_percentile: float = 10
    ) -> pd.DataFrame:
        """Correlation during stress periods."""
        port_returns = self.returns @ self.weights
        threshold = np.percentile(port_returns, threshold_percentile)
        stress_mask = port_returns <= threshold
        return self.returns[stress_mask].corr()

Pattern 3: Rolling Risk Metrics

python

class RollingRiskMetrics:
    """Rolling window risk calculations."""

    def __init__(self, returns: pd.Series, window: int = 63):
        """
        Args:
            returns: Return series
            window: Rolling window size (default: 63 = ~3 months)
        """
        self.returns = returns
        self.window = window

    def rolling_volatility(self, annualized: bool = True) -> pd.Series:
        """Rolling volatility."""
        vol = self.returns.rolling(self.window).std()
        if annualized:
            vol *= np.sqrt(252)
        return vol

    def rolling_sharpe(self, rf_rate: float = 0.02) -> pd.Series:
        """Rolling Sharpe ratio."""
        rolling_return = self.returns.rolling(self.window).mean() * 252
        rolling_vol = self.rolling_volatility()
        return (rolling_return - rf_rate) / rolling_vol

    def rolling_var(self, confidence: float = 0.95) -> pd.Series:
        """Rolling historical VaR."""
        return self.returns.rolling(self.window).apply(
            lambda x: -np.percentile(x, (1 - confidence) * 100),
            raw=True
        )

    def rolling_max_drawdown(self) -> pd.Series:
        """Rolling maximum drawdown."""
        def max_dd(returns):
            cumulative = (1 + returns).cumprod()
            running_max = cumulative.cummax()
            drawdowns = (cumulative - running_max) / running_max
            return drawdowns.min()

        return self.returns.rolling(self.window).apply(max_dd, raw=False)

    def rolling_beta(self, market_returns: pd.Series) -> pd.Series:
        """Rolling beta vs market."""
        def calc_beta(window_data):
            port_ret = window_data.iloc[:, 0]
            mkt_ret = window_data.iloc[:, 1]
            cov = np.cov(port_ret, mkt_ret)
            return cov[0, 1] / cov[1, 1] if cov[1, 1] != 0 else 0

        combined = pd.concat([self.returns, market_returns], axis=1)
        return combined.rolling(self.window).apply(
            lambda x: calc_beta(x.to_frame()),
            raw=False
        ).iloc[:, 0]

    def volatility_regime(
        self,
        low_threshold: float = 0.10,
        high_threshold: float = 0.20
    ) -> pd.Series:
        """Classify volatility regime."""
        vol = self.rolling_volatility()

        def classify(v):
            if v < low_threshold:
                return "low"
            elif v > high_threshold:
                return "high"
            else:
                return "normal"

        return vol.apply(classify)

Pattern 4: Stress Testing

python

class StressTester:
    """Historical and hypothetical stress testing."""

    # Historical crisis periods
    HISTORICAL_SCENARIOS = {
        "2008_financial_crisis": ("2008-09-01", "2009-03-31"),
        "2020_covid_crash": ("2020-02-19", "2020-03-23"),
        "2022_rate_hikes": ("2022-01-01", "2022-10-31"),
        "dot_com_bust": ("2000-03-01", "2002-10-01"),
        "flash_crash_2010": ("2010-05-06", "2010-05-06"),
    }

    def __init__(self, returns: pd.Series, weights: pd.Series = None):
        self.returns = returns
        self.weights = weights

    def historical_stress_test(
        self,
        scenario_name: str,
        historical_data: pd.DataFrame
    ) -> Dict[str, float]:
        """Test portfolio against historical crisis period."""
        if scenario_name not in self.HISTORICAL_SCENARIOS:
            raise ValueError(f"Unknown scenario: {scenario_name}")

        start, end = self.HISTORICAL_SCENARIOS[scenario_name]

        # Get returns during crisis
        crisis_returns = historical_data.loc[start:end]

        if self.weights is not None:
            port_returns = (crisis_returns @ self.weights)
        else:
            port_returns = crisis_returns

        total_return = (1 + port_returns).prod() - 1
        max_dd = self._calculate_max_dd(port_returns)
        worst_day = port_returns.min()

        return {
            "scenario": scenario_name,
            "period": f"{start} to {end}",
            "total_return": total_return,
            "max_drawdown": max_dd,
            "worst_day": worst_day,
            "volatility": port_returns.std() * np.sqrt(252)
        }

    def hypothetical_stress_test(
        self,
        shocks: Dict[str, float]
    ) -> float:
        """
        Test portfolio against hypothetical shocks.

        Args:
            shocks: Dict of {asset: shock_return}
        """
        if self.weights is None:
            raise ValueError("Weights required for hypothetical stress test")

        total_impact = 0
        for asset, shock in shocks.items():
            if asset in self.weights.index:
                total_impact += self.weights[asset] * shock

        return total_impact

    def monte_carlo_stress(
        self,
        n_simulations: int = 10000,
        horizon_days: int = 21,
        vol_multiplier: float = 2.0
    ) -> Dict[str, float]:
        """Monte Carlo stress test with elevated volatility."""
        mean = self.returns.mean()
        vol = self.returns.std() * vol_multiplier

        simulations = np.random.normal(
            mean,
            vol,
            (n_simulations, horizon_days)
        )

        total_returns = (1 + simulations).prod(axis=1) - 1

        return {
            "expected_loss": -total_returns.mean(),
            "var_95": -np.percentile(total_returns, 5),
            "var_99": -np.percentile(total_returns, 1),
            "worst_case": -total_returns.min(),
            "prob_10pct_loss": (total_returns < -0.10).mean()
        }

    def _calculate_max_dd(self, returns: pd.Series) -> float:
        cumulative = (1 + returns).cumprod()
        running_max = cumulative.cummax()
        drawdowns = (cumulative - running_max) / running_max
        return drawdowns.min()

Quick Reference

python

# Daily usage
metrics = RiskMetrics(returns)
print(f"Sharpe: {metrics.sharpe_ratio():.2f}")
print(f"Max DD: {metrics.max_drawdown():.2%}")
print(f"VaR 95%: {metrics.var_historical(0.95):.2%}")

# Full summary
summary = metrics.summary()
for metric, value in summary.items():
    print(f"{metric}: {value:.4f}")

Best Practices

Do's

• Use multiple metrics - No single metric captures all risk
• Consider tail risk - VaR isn't enough, use CVaR
• Rolling analysis - Risk changes over time
• Stress test - Historical and hypothetical
• Document assumptions - Distribution, lookback, etc.

Don'ts

• Don't rely on VaR alone - Underestimates tail risk
• Don't assume normality - Returns are fat-tailed
• Don't ignore correlation - Increases in stress
• Don't use short lookbacks - Miss regime changes
• Don't forget transaction costs - Affects realized risk

Resources

• Risk Management and Financial Institutions (John Hull)
• Quantitative Risk Management (McNeil, Frey, Embrechts)
• pyfolio Documentation