Financial Risk Manager Part 1
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Mary Noel, FRM, is tasked with analyzing the returns of two different assets – A and B. She finds that the two assets have the same mean, variance, and skewness, but A has a higher kurtosis than B. Which of the following statements is most likely true?
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A
Asset A is riskier than asset B.
B
Asset B is riskier than asset A.
C
Both assets are highly profitable.
D
Assets A and B will earn negative returns in the long term.
Explanation:
Explanation
Kurtosis measures the "tailedness" of a probability distribution - specifically, it indicates the presence and frequency of extreme values (outliers) in the data.
Key Points:
- Higher kurtosis indicates a distribution with fatter tails, meaning there's a higher probability of extreme values occurring
- Since both assets have the same mean, variance, and skewness, the only difference is in kurtosis
- Asset A having higher kurtosis means it has more extreme returns (both positive and negative) than Asset B
- In financial risk management, extreme negative returns represent significant risk
- Therefore, Asset A is riskier because it has a higher likelihood of experiencing extreme losses
Why other options are incorrect:
- B: Incorrect - Asset B has lower kurtosis, meaning fewer extreme returns and thus lower risk
- C: Incorrect - Mean returns are the same for both assets, and kurtosis doesn't indicate profitability
- D: Incorrect - Mean returns are the same, and kurtosis doesn't predict long-term negative returns
Conclusion: Higher kurtosis = higher tail risk = higher overall risk, making Asset A the riskier investment.
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