Académique Documents
Professionnel Documents
Culture Documents
s
is dtermined by the ACP (same way than for the VaR) :
s
= 3 + x
s
+ y
s
IV. Use of VaR for capital requirements
Deletion of the Add-on for specific risk, replaced by 2 new add-ons,
calculated at least weekly , for a time horizon of 1 year, and at a confidence
interval of 99,9%. These add-on will not be detailed in this presentation.
IRC (Incremental Risk Charge) add-on, to better capture default risk as
well as rating migration risk for credit trading portfolios, except for
correlation trading products (CDO : Collaterized Debt Obligations):
Max ( last IRC calculation, average on the 12 last weeks).
CRM (Comprehensive Risk Measure) add-on : to better capture rating
15 10/21/2011
CRM (Comprehensive Risk Measure) add-on : to better capture rating
migration and default risk for correlation trading products:
Max ( last CRM calculation, average on the 12 last weeks), with a
floor in the requirement.
In European Union, these models should be used for 12/31/2011 capital
adequacy computations for banks whose VaR has already been
approved by the supervisors, otherwise :
Use of the standard approach if stressed VaR not approved;
Use of the standard method for specific risk if IRC/CRM not approved.
V. Computation of the VaR
1 Risk factors
Risk factors are generally market data whose variations affect the
valuation of the positions. Sometimes they are deduced from market
data.
They have to be identified precisely for each type of instruments before
computing the VaR,
Their choice is specific to each bank and varies during the time,
The same parameters are often used for P&L and VaR purposes.
16 10/21/2011
At first, choice of the market risk factors, denoted X
i
hereafter, which may
be correlated :
Interest rates,
Equity /indices prices,
Foreign Exchange rates,
Credit spreads,
Commodity prices,
Option implied volatilities,
V. Computation of the VaR
The daily variations of the price of the trading book (ie the daily P&L) is
supposed to be entirely explained by the variation of these risk factors.
But it happens that some market parameters are not risk factors, for
example when these data :
have a very small impact on the VaR : the bank has to justify its choice,
are difficult to observe on a daily basis (dividend forecasts or repos rates,
implicit correlations between stocks and indices used to price some equity
structured products, ) : specific risk indicators must be calculated to
follow the risk they generate.
17 10/21/2011
follow the risk they generate.
Modeling risk factors correlation for a long only portfolio is completely
different than for a long/short portfolio :
For a long only portfolio, overestimating correlations may generally lead to
an overestimation of the risks through an underestimation of the
diversification effect,
For a long / short portfolio, overestimating correlations may lead to a
significant underestimation of the risks, as it may overestimate some
compensation (hedging) effects between instruments.
V. Computation of the VaR
2 Modeling
The computation of the VaR is not straightforward and needs some
modeling techniques.
Then, 3 main approaches can be developed to compute the VaR :
18 10/21/2011
Parametric approach (a)
Historical simulation (b)
Monte Carlo simulation (c)
Each approach has its advantages.
V. Computation of the VaR
2.a Parametric VaR
V(t) : Valuation of the portfolio at t, function of the values of the risk
factors X
i
Two main additional hypothesis :
The variation of the price of the portfolio can be represented by its
( ) ( ) ( ) ( ) [ ] t X t X t X F t V
n
,..., ,
2 1
=
19 10/21/2011
The variation of the price of the portfolio can be represented by its
first order derivatives :
The variation of the risk factors X
i
is assumed to follow a
Gaussian law.
Consequently V(t,t+dt) is distributed following a Gaussian law
N(0 ; (V)), because its mean is neglected.
( ) ( ) ( )
i
n
i
i
dX
X
F
t V dt t V dt t t V
=
|
|
\
|
+ = +
1
,
V. Computation of the VaR
Its standard deviation (V) is given by :
( )
(
(
(
(
(
(
(
(
(
(
=
n n
n n
X
F
X
F
X
F
X
F
X
F
V
(
(
(
=
n
n n n n n
n
X
F
X
X X X
V
...
...
... ... ... ...
,..., ,
2
2
2 2 1 1
2 1
V. Computation of the VaR
The 1-day VaR will be given by :
VaR (1 day) = k
x
(V)
Where k
x
is the x% percentile of a Gaussian distribution (for x=99%, this
coefficient will be equal to 2,33).
21 10/21/2011
VaR(99%, 1 day) = 2,33 x (V)
This methodology will be adapted only to linear portfolios.
V. Computation of the VaR
2.b Historical simulation
The daily variations of the risk factors are supposed to be stationary.
Step 1 : compute the 260 scenarios corresponding to the daily variations of
the risk factors observed during the last year,
Step 2 : apply these variations to today prices : one obtains 260 possible
values for the risk factors tomorrow,
22 10/21/2011
values for the risk factors tomorrow,
Step 3 : price the portfolio for each of these 260 scenarios.
The VaR will be the 1% percentile of these scenarios if sorting them from
the worst to the best.
So for a time series of 1 year for the risk factors, the VaR is between the
2
nd
and the 3
rd
worst cases.
Sometimes banks take 300 days time series for the VaR to be the 3
rd
worst case.
V. Computation of the VaR
Some approximations may be used to compute the price of the trading
book for each of the scenarios because there are so many valuations as
days in the time series.
In theory, estimating a 1% percentile with only 260 scenarios should not
give a precise estimation.
In practice, as the daily variations of market prices are not independent,
23 10/21/2011
In practice, as the daily variations of market prices are not independent,
the convergence of the VaR estimator is generally quite acceptable.
When historical data are not available for a given risk factor, some proxy
have to be used.
There are no assumptions on the statistical distribution of the risk factors
or on their correlations.
V. Computation of the VaR
2.c Monte Carlo simulation
The daily variations of the risk factors follow a given statistical distribution
(not necessarily Gaussian).
Step 1 : estimate the parameters of the distribution of the risk factors,
Step 2 : simulate randomly N (typically 10 thousands or more) possible
variations of the risk factors, taking into account the correlations between
24 10/21/2011
variations of the risk factors, taking into account the correlations between
the risk factors,
Step 3 : price the portfolio for each of these N scenarios.
The VaR will be the 1% percentile of the value of the portfolio on the N
scenarios.
V. Computation of the VaR
Monte Carlo simulation could appear as the most sophisticated (one can
easily add risk factors,).
But this technique is time consuming. Some institutions may then use
some simplifications :
They may choose a reduced number of risk factors, or simplify their
25 10/21/2011
They may choose a reduced number of risk factors, or simplify their
correlation structure,
They may use simplified valuation techniques or even approximate the
variation of the price of the portfolio by its first or second order sensitivities,
They may reduce the number of simulations.
V. Computation of the VaR
3. Importance of the risk factors time series in the VaR calculation
The observation period of the market data and their variations has a
significant impact on the results of the VaR calculation :
For historical simulations : the shocks applied to the positions are the
26 10/21/2011
For historical simulations : the shocks applied to the positions are the
observed variations on the risk factors ;
For parametric calculation and Monte Carlo simulations : the dynamics of
the risk factors and the way they are linked (represented by the variance-
covariance or the correlation matrix) depend on their past evolutions.
V. Computation of the VaR
Main components :
The length of the time series and the characteristics of the market
during this period : when a time series corresponds to a calm
period, for a given position the VaR decreases.
The update frequency of the time series of risk factors (and so of
shocks or correlation structure, depending on the methodology
27 10/21/2011
shocks or correlation structure, depending on the methodology
chosen),
Between 2 updates of the risk factors, the new shocks are not taken
into account in the VaR, so the amount of the VaR may be under or
over estimated ;
The P&L is calculated with real market data. So in case of important
moves of the markets (high volatilities of the markets), the back-testing
may fail.
V. Computation of the VaR
Regulatory requirements
Minimum length of the observation period : 1 calendar year (= 262 days or
261 daily excepting week-ends and 1
st
of january )
Update at least every month, more often in case of high volatilities of the
markets
In France, most banks use one year time series for risk factors.
If this year corresponds to a crisis period, the VaR amounts will be high;
28 10/21/2011
If this year corresponds to a crisis period, the VaR amounts will be high;
If it corresponds to a quiet period, the VaR amounts will be lower.
The market data are generally updated :
Daily for historical simulations : every day the oldest data are replaced by
the most recent one.
For a VaR calculated on End Of Day D market data, the latest shocks
are the risk factors variations between D-1 and D-2.
Monthly or twice a month for parametric calculations and Monte Carlo
simulations, to determine the variance-covariance matrix or the historical
volatilities.
V. Computation of the VaR
4. Aggregation of the VaR
VaR calculations :
At aggregated level
At portfolio level, business line, trader level, , to identify the most risky ones.
The sum of the VaR from different activities is not equal to the VaR
calculated on the whole activity.
The difference between these 2 calculations represent the netting effect
between different activities.
29 10/21/2011
The computation should be made at the trading book level. Computing
VaR-like indicators for different risk factors / portfolio and sum them
should not be considered as acceptable.
When different methodologies are used to calculate the VaR, depending
on the activity, the global VaR is the sum of the VaR calculated with each
of these methodologies, and diversification effect are not taken into
account.
V. Computation of the VaR
5. VaR production
Institutions which have been authorized to use their internal model
have to calculate a VaR daily .
It is time consuming process :
Feed the trading positions in the calculation engine,
Feed and update of market data (and for historical simulations, of the
30 10/21/2011
Feed and update of market data (and for historical simulations, of the
shocks),
Valuations of the portfolio (which take a long time for historical and Monte
Carlo simulations).
V. Computation of the VaR
6 Other remarks about the VaR
VaR does not provide accurate risk measurements for activities whose
potential losses have very high amplitudes and occurrence probability
less than 1%.
VaR generally doesnt provide satisfying measure of risk for some types
of positions, for which the capital requirement is to be estimated using the
standard method if no specific processing has been developed, for
example :
31 10/21/2011
Event risk (mergers,) which may affect significantly risk arbitrage desks :
VaR is based on time series of equity prices and generally doesnt take into
account sudden spreads increases between the prices of the two stocks,
which induce losses in case of failure of the transaction;
Hedge funds (liquidation values mostly not available on a daily basis) :
stress scenarios may be useful.
V. Computation of the VaR
The VaR is a synthetic indicator which measures a confidence interval of
the potential losses. It does not give any information about the maximal
loss or at any other percentile.
Without further information, it is not possible to determine the part of the
various risk factors and the influence of the size of the positions in the
evolution of the VaR amounts.
Basel requires the VaR to be used for daily risk-monitoring purposes
(use-tests).
32 10/21/2011
(use-tests).
VaR limits are generally defined for different aggregation levels.
But VaR is not an operational indicator to monitor positions of the traders
(these are monitored by sensitivities indicators and various limits defined
for finest levels).
The coherence between operational and VaR limits has to be checked.
VI. Back-testing
Back-testing : Institutions have to compare daily Profit and Losses (P&L)
to VaR figures (not in absolute real values, negative) :
It is required to be done at least quarterly on the 250 last business days.
Two P&L :
Hypothetical P&L : changes in the portfolio value calculated on end of day
positions unchanged;
Real P&L : actual trading outcomes, (i.e daily changes in portfolio value
33 10/21/2011
Real P&L : actual trading outcomes, (i.e daily changes in portfolio value
(excluding fees, commissions and net interest incomes),
Supervisors require banks to perform back-testing on one of these P&L
or both.
In France, since 2011, both have to be back-tested.
A back-testing is required on the VaR and on the VaR for specific risk.
VI. Back-testing
The add-on for capital requirements depends on the number of failures of
the back-testing.
Number of failures = number of days for which :
P&L <0 and P&L < VaR (VaR is a negative amount).
Number of failures Add-on
34 10/21/2011
Number of failures Add-on
< 5 0
5 0,4
6 0,5
7 0,65
8 0,75
9 0,85
10 or more 1
VI. Back-testing
DAILY P/L ( M tM ) / VaR 99 1 DAY 99%
0 .0
1 0 0 0 0 .0
2 0 0 0 0 .0
3 0 0 0 0 .0
(USD )
R eal / C lean M t M R ISK T heo ret ic al P / L
35 10/21/2011
In theory, losses should exceed the 1 day VaR around 1% of the cases.
-3 0 0 0 0 .0
-2 0 0 0 0 .0
-1 0 0 0 0 .0
0 .0
VII. Stress-tests
Three sets of stress-tests are required in order for an internal model to be
validated:
Historical stress-tests;
Hypothetical stress-tests;
Adverse stress-tests.
Institutions frequently use the same systems for VaR calculation and stress-
tests.
36 10/21/2011
But sometimes two independent processes exist, one for the VaR, and one
for the stress-tests :
P&L calculations with sensitivities suppose the risk factors variations to be small.
So they shouldnt not be used for stress-tests, which assume the shocks to be
important.
So in case of VaR calculation with a sensitivity approach, stress-tests could for
example be estimated with full valuations.
VIII. Validation by supervisors
Calculation engine :
Input :
Market Data :
Identification of those which are risk factors
Historical data time series
Variance/covariance matrix
For historical simulations, update of the shocks
Portfolio data : positions, sensitivities
37 10/21/2011
Portfolio data : positions, sensitivities
Valuations of the portfolio and VaR calculation
Output :
VaR
Stress-tests
Back-testing
Risk-monitoring
VIII. Validation by supervisors
The whole calculation engine has to be examined
The quality of the inputs and the robustness of the VaR architecture
system are essential.
Because of the important number of steps in the VaR computation, risks
of failure somewhere in the process are significant.
So procedures to solve production incidents have to be set up.
38 10/21/2011
So procedures to solve production incidents have to be set up.
Impacts of the incidents on the VaR measurements have to be analyzed,
for the supervisor to be able to have an opinion on the quality of the VaR
production process.
VIII. Validation by supervisors
Modeling choices must be appreciated depending on the portfolio for
which they will be used.
The validity of these choices may vary over time :
For example, if an institution develops new trading activities, or optimizes
the hedging of its main risks, it may have to improve its VaR methodology;
The statistical distribution of market prices daily variation may change over
39 10/21/2011
The statistical distribution of market prices daily variation may change over
time : a market parameter that remains unchanged may become volatile,
two market parameters that were historically perfectly correlated may
become independent.
A too conservative approach should not be recommended :
overestimation of a risk could hide the fact that an other risk may be
underestimated.
VIII. Validation by supervisors
Risk factors
Historical data used to compute the VaR should be verified, they should
be coherent with data used to compute daily P&L.
Some points to review :
Are the selected risk factors representative of the activities?
40 10/21/2011
Is there a good granularity?
Sometimes the number of points is reduced to reduce the computing
time (for example on interest rates).
Use of data sources to estimate the scenarios of the VaR different from
the one used for the daily valuation.
For market whose feed in the system is automatic (Bloomberg,
Reuters,), which market makers, time window, price, to
choose?
VIII. Validation by supervisors
How to replace missing data in the time series ?
Rules to complete these data when no historical prices can be found must
be defined. This is particularly important for risk factors specific to an
institution. (e.g. : use of a proprietary model to represent the smile effect).
How to deal with a new risk-factor (e.g. a newly issued stock) with less than
1 year historical or with illiquid parameters for which daily quotations are not
available?
41 10/21/2011
Which frequency do we choose for the updates ?
When no time series are available, is the proxy used a good
one ?
Adequacy between risk factors and positions
VIII. Validation by supervisors
Portfolio valuation techniques
Monte Carlo and historical simulations being time consuming, if approximated valuation
techniques are used, one should check that the approximations are acceptable, for
example :
compare sensitivities (delta, vega,) computed using exact and approximated
valuation models on the different portfolios;
Compare P&L calculated by full valuations and by sensitivities;
For sensitivities based approaches :
Are the sensitivities computations correct ?
42 10/21/2011
Are the sensitivities computations correct ?
Are they coherent across products ?
Do they explain the risks of the portfolio ?
More the models are simplified, more the quality of the VaR is unreliable.
Control of the exhaustiveness of the positions :
For positions for which there is no VaR computation, capital requirements are
calculated using the standard approach;
The supervisor checks that for each entity of the institution, a capital is
calculated (VaR or standard method) for every trading position.
VIII. Validation by supervisors
Back-testing and P&L attribution
If it is made at different portfolio level, back-testing is a very useful tool to
assess the quality of the VaR computation.
An other very useful technique is to verify that the risk factors of the VaR
and the representation of portfolio chosen (sensitivities, approximated
valuation models) explain correctly the daily Profit & Loss.
43 10/21/2011
valuation models) explain correctly the daily Profit & Loss.
Such decomposition of the P&L by risk factors is generally called P&L
attribution and may be computed by some institutions.
IX. Stressed VaR
This measure is intended to replicate VaR calculation that would be
generated on the banks current portfolio if the relevant market factors
were experiencing a period of stress.
Based on a 10 days, 99
th
percentile, one-tailed confidence interval VaR
measure of the current portfolio
Model inputs calibrated to historical data from a continuous 12-month
44 10/21/2011
Model inputs calibrated to historical data from a continuous 12-month
period of significant stress relevant to the banks portfolio.
The period must be approved by the supervisor and regularly reviewed.
For example, for many portfolios, a 12-month period relating to significant
losses in 2007/2008 would adequately reflect a period of such stress;
although other periods relevant to the current portfolio must be
considered by the bank (Reference [2])
X. Conclusion
Generally, more portfolio are hedged or complex,
Containing structured (exotic) and highly non linear transactions,
Making some thin arbitrage (deformation of a yield curve, arbitrage between
correlated products,),
Trading on illiquid markets,
more computing the VaR may be difficult and may need sophisticated tools.
45 10/21/2011
The whole calculation engine has to be examined by the supervisor for him to
determine whether, or not, an institution can be allowed to use its internal
models for prudential purposes.
Since the financial crisis began in mid-2007, the Basel Committee on Banking
Supervision has completed the market risk framework with IRC, CRM and
Stressed VaR which also have to be approved by the supervisors.
The BCBS has also started a fundamental review of trading activities.