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Titre original : Perignon Smith 10 Diversification and Value-At-Risk

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Christophe Prignon

a

, Daniel R. Smith

b,

*

a

HEC Paris, F-78351 Jouy-en Josas, France

b

Simon Fraser University, 8888 University Drive, Burnaby BC V6P 2T8, Canada

a r t i c l e i n f o

Article history:

Received 17 May 2008

Accepted 5 July 2009

Available online 9 July 2009

JEL classication:

G21

G28

G32

Keywords:

Value-at-Risk

Diversication

Dynamic conditional correlation

Copulas

a b s t r a c t

A pervasive and puzzling feature of banks Value-at-Risk (VaR) is its abnormally high level, which leads to

excessive regulatory capital. A possible explanation for the tendency of commercial banks to overstate

their VaR is that they incompletely account for the diversication effect among broad risk categories

(e.g., equity, interest rate, commodity, credit spread, and foreign exchange). By underestimating the

diversication effect, banks proprietary VaR models produce overly prudent market risk assessments.

In this paper, we examine empirically the validity of this hypothesis using actual VaR data from major

US commercial banks. In contrast to the VaR diversication hypothesis, we nd that US banks show no

sign of systematic underestimation of the diversication effect. In particular, diversication effects used

by banks is very close to (and quite often larger than) our empirical diversication estimates. A direct

implication of this nding is that individual VaRs for each broad risk category, just like aggregate VaRs,

are biased risk assessments.

2009 Elsevier B.V. All rights reserved.

1. Introduction

Most modern commercial banks routinely publicly disclose their

aggregate, rm-level Value-at-Risk (VaR). The latter measures the

maximum trading loss that a bank can face over a given horizon

(usually one day) and under a specied condence level (usually

99%). A pervasive and puzzling feature of banks VaR is its abnor-

mally high level. Indeed, Berkowitz and OBrien (2002) show that

US banks 99% VaR systematically exceed the actual 99 percentile

of their trading revenues and that GARCH-based VaR models tted

to actual daily trading revenues lead to smaller VaR estimates. Pri-

gnon et al. (2008) nd that, because of VaR overstatement, market

risk charges of Canadian banks are much larger (ve times larger for

some banks) than it would be with unbiased VaR estimates. Out of

the 7354 trading days analyzed in their study, there are only two

exceptions, or days when the actual trading loss exceeds the VaR,

whereas the expected number of exceptions with a 99% VaR is

74.

1

The direct cost for the bank to over-report its VaR is to maintain

an excessively high regulatory capital since its level is given by a po-

sitive function of the bank (average or most recent) VaR.

2

A rst at-

tempt to quantify empirically the cost of VaR over-reporting can be

found in Prignon et al. (2008).

An increasing number of banks also report an individual VaR for

each broad risk category (e.g., equity, interest rate, commodity,

credit spread, and foreign exchange). In their international survey,

Prignon and Smith (forthcoming) nd that 68% of their sample

rms publicly disclose individual VaRs. This particular disclosure

format allows outsiders to have a good understanding of the cur-

rent exposure of banks trading portfolio with respect to the main

sources of risk in the economy. As acknowledged by the Basel Com-

mittee on Banking Supervision (1996) in the Amendment of the

Based Accord, banks have discretion to recognize empirical corre-

lations within and across broad risk categories when computing

their aggregate or diversied VaR. In practice, because the correla-

tion across the risks is less than perfectly positive, the aggregate

VaR will be less than the sum of the individual VaRs.

3

A possible explanation for the tendency of commercial banks to

overstate their aggregate VaR is that they incompletely account for

the diversication effect among broad risk categories (see Berko-

witz and OBrien, 2002; Prignon et al., 2008). We refer to this con-

jecture as the diversication hypothesis. Under this hypothesis,

even with unbiased individual VaRs, the aggregate VaR will be

too large and the number of exceptions too small. If the diver-

sication hypothesis is valid (i.e., biased correlation structure),

0378-4266/$ - see front matter 2009 Elsevier B.V. All rights reserved.

doi:10.1016/j.jbankn.2009.07.003

* Corresponding author. Tel.: +1 778 782 4675; fax: +1 778 782 4920.

E-mail addresses: perignon@hec.fr (C. Prignon), drsmith@sfu.ca (D.R. Smith).

1

See Prignon and Smith (forthcoming) for further international evidence of VaR

over-reporting.

2

This phenomenon has been labeled by Bakshi and Panayotov (2007) as the

Capital Adequacy Puzzle. Breuer et al. (2009) argue that simply adding market and

credit risk charges tends to understate aggregate capital requirements.

3

As Deutsche Bank puts it in its 2005 annual report: Simply adding the Value-at-

Risk gures of the individual risk classes to arrive at an aggregate Value-at-Risk would

imply the assumption that the losses in all risk categories occur simultaneously.

Journal of Banking & Finance 34 (2010) 5566

Contents lists available at ScienceDirect

Journal of Banking & Finance

j our nal homepage: www. el sevi er . com/ l ocat e/ j bf

individual VaRs have a chance to be informative. However, if the

diversication hypothesis is not valid (i.e., correlation structure

properly accounted for), individual VaRs are causing the Capital

Adequacy Puzzle, and as a result, are biased risk assessments.

Although there are many potential motivations for banks to over-

state VaR, at least two relate to the regulatory environment facing

US (and many other countrys) banks. One such explanation for

VaR inating comes from the asymmetric cost function faced by

the banks. If the number of exceptions is too small (i.e., large

VaR), the cost corresponds to the cost of maintaining an excessive

regulatory capital, whereas if the number of exceptions is too large

(i.e., small VaR), the cost increases exponentially with the number

of exceptions (e.g., severe regulatory penalties, reputation effects).

Furthermore, under the US regulatory environment banks are re-

quired to estimate their VaR using at least one year of daily histor-

ical data. This leads to a sluggish dynamics for the VaR especially

when it is computed through historical simulations (Pritsker,

2006). In order to prevent clusters of exceptions in case of sudden

increase of volatility, VaR is inated.

The goal of this paper is to empirically test the validity of the

VaR diversication hypothesis. Our analysis is based on individual

and diversied VaR data from several major US commercial banks

between 2001 and 2007. For each bank/quarter, we compute the

actual diversication applied by the bank as d =

N

i=1

VaR

i

_

DVaR)=

N

i=1

VaR

i

, where DVaR and VaR

i

are the diversied, respec-

tively individual, 99% 1-day ahead VaRs disclosed by the bank and

N is the number of broad risk categories.

4

In our sample, there are

ve broad risk categories, i.e., equity, interest rate, commodity, credit

spread, and foreign exchange. Empirically, we nd that the d coef-

cient is typically in the 3455% range. We then compare the actual

diversication effect used by the bank to a benchmark estimated

from market indices that capture the ve broad risk categories. Spe-

cically, we aggregate the banks individual VaRs using an empirical

estimate of the correlation structure among risk category indices and

derive an empirical DVaR denoted DVaR

E

. In our tests, we model the

correlation structure using a variety of techniques: unconditional

correlation matrices, Dynamic Conditional Correlation model, BEKK

model, and a time-varying copula model.

The empirical diversication coefcient is dened as d

E

=

N

i=1

VaR

i

DVaR

E

_ __

N

i=1

VaR

i

and it is used as a benchmark for

the banks d. Supportive evidence for the VaR diversication

hypothesis would be nding d

E

d. However, our main result is

that the diversication effect used by most banks is very close to

(and quite often larger than) our empirical diversication estimate.

Overall, our results do not lend support to the hypothesis that VaR

over-reporting is primarily due to a partial account of the diversi-

cation among broad risk categories. A direct implication of this

nding is that individual VaRs, just like aggregate VaRs, are biased

risk assessments.

This study makes three contributions to the nancial risk man-

agement literature. First, we directly test the diversication

hypothesis using actual data on aggregate and individual VaRs.

Second, our empirical analysis can be viewed as the rst (indirect)

test of the accuracy of individual VaRs. Indeed, standard backtest-

ing procedures cannot be directly implemented on individual VaRs

since there is no available time-series data on prot-and-loss

disaggregated by source of risk. Third, we show how the recent

copula models with time-varying dependence parameter a la Pat-

ton (2006), Jondeau and Rockinger (2006), or Bartram et al.

(2007) can be used to compute the VaR of a given portfolio.

The rest of the paper is organized as follows. We present our

methodology in the next section and our empirical analysis in Sec-

tion 3. Robustness checks and extensions are discussed in Section

4. We summarize and conclude our study in Section 5.

2. Methodology

In this section, we present a methodology allowing us to com-

pute (1) the bank diversication coefcient and (2) the empirical

diversication coefcient from banks individual VaRs and risk

category indices. We denote the vector of asset returns by r and

its covariance matrix by H = DRD, where D is a diagonal matrix

with the standard deviation of asset i as element i on the princi-

pal diagonal: D = diag(r

i

), R is the correlation matrix, and

i = 1, . . . , N. A portfolio with weight x

i

in asset i has rate of return

r

p

= x

/

r and variance r

2

p

= x

/

Hx. If the total investment measured

in dollars is W then the dollar variance, which is required for

computing VaR, is r

2

p

W

2

= x

/

Hx where x = xW are the dollar posi-

tions. The VaR of the investment in asset i, or individual VaR, is

given by:

VaR

i

= jr

i

x

i

W = jr

i

x

i

(1)

and, as shown by Jorion (2006), the diversied VaR of the portfolio

is:

DVaR = j

x

/

Hx

_

: (2)

The scaling coefcient j depends on the particular distribution and

the coverage probability. For instance, when computing a 99% VaR

using a normal distribution, j = 2.33. Eq. (2) is most easily derived

under the assumption of multivariate normality, but applies

equally to the family of elliptical distributions (with j suitably

re-dened), which is a much broader class of distributions (see Jori-

on, 2006, p. 180 and, Appendix A for a proof). Combining individual

and diversied VaRs, we dene the bank diversication coefcient

as:

d =

N

i=1

VaR

i

DVaR

N

i=1

VaR

i

: (3)

We rewrite Eq. (2) as a function of the individual VaRs:

DVaR = j

x

/

DRDx

_

=

j

2

x

/

DRDx

_

=

V

/

RV

_

; (4)

where V is a column vector containing the individual VaRs. Eq. (4)

provides a very simple approach to computing the diversication

effect among a set of assets whose joint distribution is in the ellip-

tical family and only requires the correlation matrix. Eq. (4) also al-

lows us to see that, in case of perfect correlation between the assets,

DVaR is given by the sum of the individual VaRs. In all other cases,

DVaR will be affected by the diversication effects.

Implementing Eq. (4) requires the estimation of the correlation

matrix. A rst approach is to simply compute the sample correla-

tion matrix of the N asset returns using past observations. Alterna-

tively, the conditional correlation matrix can be computed using

the Dynamic Conditional Correlation (DCC) of Engle (2002), which

is a powerful tool for quickly estimating moderately high-dimen-

sional GARCH models. This model is based on a decomposition of

the log-likelihood function of a multivariate GARCH model. We

use quasi-maximum likelihood to estimate the parameters

describing the conditional covariance matrix H

t

= E(e

t

e

/

t

) = D

t

R

t

D

t

where e

t

= r

t

E

t1

(r

t

) denotes the unexpected returns and D

t

is a

diagonal matrix of conditional standard deviations that are mod-

eled as univariate GARCH models:

D

2

t

= diag(x

i

) diag(a

i

) (e

t1

e

/

t1

) diag(b

i

) D

2

t1

; (5)

4

To the best of our knowledge, this is the rst study to measure a diversication

coefcient from VaR data. We nd this measure appealing because of its simplicity

(i.e., percentage reduction in VaR due to diversication among sources of risk) and

because it can be computed for each bank at any point in time.

56 C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566

where denotes the Hadamard or element-by-element multiplier

and R

t

is the conditional correlation matrix. The correlation matrix

is expressed as:

R

t

= diag(Q

t

)

1=2

Q

t

diag(Q

t

)

1=2

(6)

and the matrix Q

t

is modeled as a GARCH-type function of the

lagged standardized residuals z

t

= D

1

t

e

t

that depends on only two

scalar parameters h

1

and h

2

:

Q

t

= R(1 h

1

h

2

) h

1

(z

t1

z

t1

) h

2

Q

t1

(7)

and R is the unconditional sample correlation matrix of the stan-

dardized residuals. The simplifying feature in the DCC model is that

the Gaussian log-likelihood function can be separated into two

components: one to identify the volatility parameters and the other

to identify the correlation parameters. The parameters that drive

the conditional variance dynamics are estimated by maximizing

the N univariate GARCH log-likelihoods, which is computationally

feasible, and then conditioning on the volatility dynamics estimate

the correlation parameters. Although we are maximizing the Gauss-

ian log-likelihood our estimates of the dynamics of the correlation

matrix apply even when returns are non-normal. We view the

Gaussian log-likelihood as simply an objective function that is max-

imized to produce quasi-maximum likelihood estimates that are

consistent and asymptotically normal and we thus report robust

standard errors.

Engle (2002) suggests a simple parameterization for the condi-

tional correlation in which h

1

and h

2

are scalars and R is set to

R,

the sample correlation matrix, so the nal stage optimization is

only with respect to two scalar parameters. If the volatility dynam-

ics are modeled using the standard GARCH(1, 1) model, which has

three parameters, then to estimate the N N covariance matrix H

t

,

there are N three-dimensional optimizations (to estimate each of

the N univariate GARCH model parameters) followed by a single

two-dimensional optimization. Thus quite high-dimensional prob-

lems can be handled computationally.

In the case of a bank disclosing its individual VaRs, we can esti-

mate the correlation matrix among risk category indices and gen-

erate from Eq. (4) the empirical DVaR which we denote by DVaR

E

.

From this alternative risk measure, we estimate an empirical diver-

sication coefcient:

d

E

=

N

i=1

VaR

i

DVaR

E

N

i=1

VaR

i

: (8)

The difference between d

E

and the bank diversication coefcient

is:

d

E

d =

DVaR DVaR

E

N

i=1

VaR

i

: (9)

By plotting the value of diversication differential d

E

d through

time for a given bank, one can see whether there is a systematic

underestimation of the diversication effect.

3. Data and empirical results

We collect quarterly data on individual and diversied VaRs

from four major US commercial banks between the fourth quarter

of 2001 and the rst quarter of 2007. Bank of America, JPMorgan

Chase, and Citigroup are the largest three US commercial banks

(in this order, based on total assets as of year-end 2005) and HSBC

ranks 8th. These banks are the only ones out of the 10 largest US

commercial banks to disclose the required information in their

10-Q and 10-K forms. Jorion (2002) and Hirtle (2003) show that

US banks quarterly VaRs do contain valuable information about fu-

ture risk exposures.

Although all sample banks disclose their VaR at the 99% con-

dence level, there are some differences in the exact nature of the

disclosed risk measures. Bank of America, Citigroup, and JPMorgan

Chase disclose their 1-day VaR whereas HSBC reported its 10-day

VaR level until the rst quarter of 2006 and then switched to a

1-day VaR. To allow cross-sectional comparisons, we convert all

10-day VaRs into 1-day VaRs using the square-root-of-time rule

(see Danielsson and Zigrand, 2006). Furthermore, Bank of America

is the only sample bank to disclose average VaRs instead of quar-

ter-end VaRs.

Consistent with previous evidence, we nd that all sample

banks over-report their VaR. Between 2001 and 2006, Bank of

America and JPMorgan Chase have experienced three and two

exceptions, respectively, whereas the expected number of excep-

tions is 15.

5

We formally test the null hypothesis that the actual

number of exceptions is equal to the theoretical one using an uncon-

ditional coverage test (see Jorion, 2006, p. 144):

z

UC

= (X 0:01 T)=

0:01 0:99 T

_

; (10)

where X is the number of exceptions, T is the length of the sample

period in days, and z

UC

is a statistic that follows a standard nor-

mal distribution. We nd that the null hypothesis is rejected at

the 1% level for Bank of America and JPMorgan Chase. The other

two sample banks do not disclose the exact number of exceptions

in their nancial reports. Instead, they report the histograms of

daily trading revenues and general statements about backtesting

that both suggest that the number of exceptions is close to zero

every year.

As shown in the left panels of Fig. 1, all banks but Citigroup

break-down their VaR into ve individual components focusing

on one major source of risk. Interest rate accounts for a large frac-

tion of a banks VaR, although credit spread became the largest

contributor to the most recent VaR of Bank of America. We also

note that for most sample banks the individual VaRs do not change

much from one quarter to the next.

6

For each sample bank, we display in the right panels of Fig. 1 a

graph of the diversied VaR. The latter measure is the sum of the

four or ve individual VaRs, i.e., the so-called undiversied VaR,

minus the diversication effect. We see that for all banks/quarters,

the undiversied VaR exceeds the diversied one, which shows

that diversication among broad sources of risk plays a central role

in determining the bank disclosed VaR.

We display in Fig. 2 a measure of the actual banks diversica-

tion effect as dened in Eq. (3). We clearly see that the level of

diversication acknowledged by the sample banks in their VaR cal-

culation is not trivial. Indeed, the average diversication coefcient

is 41.2% and rm-specic values range from 33.9% for HSBC to

54.6% for Bank of America. The latter gure suggests that ignoring

diversication would lead Bank of America to double both its DVaR

and its market risk charge. At times, the diversication acknowl-

edged by HSBC is clearly smaller than those of other sample banks.

For instance, during three quarters in 2004, the HSBCs diversica-

tion coefcient was between 4% and 12%. We also note that the

strength of the diversication effect varies through time and that

all sample banks have at least one quarter with a diversication

coefcient in excess of 50%.

7

5

Numbers of exceptions per year have been obtained from rms nancial

statements.

6

The interest rate VaR of HSBC is an exception. For instance, between 2005-Q4 and

2006-Q1, the 10-day interest rate VaR jumped from 22 million to 143 million (the

corresponding 1-day VaR jumped from 7 million to 45.2 million).

7

There are two reasons for the diversication coefcient to vary through time: (1)

correlations between broad risk categories are time-varying and (2) the composition

of the trading portfolio changes from one quarter to the next.

C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566 57

For comparison purposes, we conduct a similar analysis using

data from ve major Canadian banks for the year 2005.

8

This alter-

native set of banks has been shown to be extremely conservative in

setting their VaR (see Prignon et al., 2008).

9

Interestingly, we nd a

very similar average diversication coefcient (40.0%) and the range

across Canadian rms is 23.649.5%.

While the diversication effects acknowledged by US banks ini-

tially appear to be quite large, we still need to investigate whether

they are large enough. To answer this question we construct a

benchmark diversication coefcient from individual VaRs and

risk category indices.

10

Our risk proxies are as follows: S&P500

Composite Index for equity; 1-Year Treasury Constant Maturity Rate

for interest rate; Dow Jones AIG Spot Commodity Index for commod-

ity; the difference between Moodys BBA corporate yield and

1-year Treasury yield for credit spread; and Trade-Weighted Major

JPMorgan Chase : VaRi

0

50

100

150

200

Credit spread

Commodity

Foreign exchange

Equity

Interest rate

JPMorgan Chase : DVaR

0

50

100

150

200

Citigroup : VaRi

0

50

100

150

200

250

Commodity

Foreign exchange

Equity

Interest rate

HSBC : VaRi

0

20

40

60

Credit spread

Commodity

Foreign exchange

Equity

Interest rate

Bank of America : VaRi

0

50

100

150

Credit spread

Commodity

Foreign exchange

Equity

Interest rate

Citigroup : DVaR

0

50

100

150

200

250

HSBC : DVaR

0

20

40

60

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1 01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1 01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

Bank of America : DVaR

0

50

100

150

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

Fig. 1. Individual and diversied Value-at-Risk. Note: This gure displays the quarterly individual VaRs (VaR

i

, left panels) and the quarterly diversied VaR (DVaR, right

panels) disclosed by our sample banks. All gures are in million of US dollars.

8

Canadian data on individual and diversied VaRs come from Table 1 in Prignon

et al. (2008).

9

Several institutional reasons could potentially explain the extreme cautiousness

of the Canadian banks when setting their VaR. First, this could be due to the

competitive environment of the Canadian banking industry. Indeed, while the top ve

US banks in 1999 accounted for just 21% of US deposits, the top ve banks in Canada

accounted for 76% of Canadian deposits. A second reason is the fact that US banks are

mainly exposed to US interest rate risk (see our Fig. 1) while Canadian banks clearly

must have large exposures to currency risk in their proprietary trading desks.

10

Berkowitz and OBrien (2007) also use risk category indices to study the exposure

of banks trading revenues to major sources of risk.

58 C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566

Currencies Dollar index for FX.

11

All risk indices are available at the

daily frequency over the period January 1991March 2007. We pro-

vide summary statistics for all risk indices in Table 1. We compute

the rst four moments of the log daily returns, as well as the Bera-

Jarque normality test. We display in the lower part of Table 1, the

unconditional correlation matrix of the returns of the ve risk

indices.

At the end of each quarter, we estimate the correlation matrix,

which is used to compute the empirical VaR for this quarter (see

Eq. (4)). For now we assume that all sample banks have a long

net position in each risk category.

12

The rst estimate of R is the his-

torical correlation matrix based on the past 250 daily observations

and the second is given by the DCC model. We display the parameter

estimates and the standard errors in Table 2. For each correlation

estimate, we estimate the empirical diversication coefcient d

E

as

in Eq. (8) and we plot the value of the diversication differential

d

E

d in Fig. 3 (unconditional correlation-based results are in the left

panels and DCC-based results are in the right panels). We note that

our computation of the diversication coefcient applies for the

wide multivariate elliptical density family and we have estimated

the DCC model parameters by quasi-maximum likelihood, which

JPMorgan Chase : Diversification

0%

20%

40%

60%

80%

100%

Citigroup : Diversification

0%

20%

40%

60%

80%

100%

HSBC : Diversification

0%

20%

40%

60%

80%

100%

Bank of America : Diversification

0%

20%

40%

60%

80%

100%

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

Fig. 2. Actual diversication. Note: This gure displays the actual diversication coefcient (in percentage) estimated from banks individual and diversied VaRs. For each

sample bank and each quarter, it is given by one minus the ratio of the diversied VaR and the sum of the individual VaRs.

Table 1

Summary statistics.

Interest rate Equity FX Commodity Credit spread

Mean 0.0077 0.0357 0.0013 0.0274 0.0216

Standard deviation 1.5221 0.9845 0.4032 0.8019 1.4085

Skewness 0.1236 0.0770 0.0347 0.3234 0.6434

Kurtosis 15.339 7.127 4.317 8.526 9.095

Bera-Jarque 40,402.2 8,722.5 3,199.9 12,551.9 14,484.4

p-Value (0.000) (0.000) (0.000) (0.000) (0.000)

Correlation matrix

Interest rate 1

Equity 0.1107 1

FX 0.1613 0.0701 1

Commodity 0.0343 0.0082 0.1299 1

Credit spreads 0.3417 0.1093 0.0814 0.0396 1

Notes: This table presents summary statistics for the daily log returns of the ve risk category indices: mean, standard deviation, skewness, kurtosis, Bera-Jarque normality

test, with its associated p-value. All risk indices are available at the daily frequency over the period January 1991March 2007. The total number of observations is 4120 for

each index. The lower panel of the table displays the correlation matrix among the returns of the ve risk category indices.

11

These indices were selected because they are popular indices and also because

they were available with a daily frequency over a long sample period. The sources of

the data are CRSP for equity, the Federal Reserve Economic Data (FRED) database for

interest rate, http://www.djindexes.com for commodity, http://www.globalnda-

ta.com for credit spread, and the Federal Reserves website for FX. The Dow Jones AIG

Spot Commodity Index is a weighted-average of the spot prices of 19 commodities.

The Trade-Weighted Major Currencies Dollar index is a weighted average of the

foreign exchange values of the US dollar against a subset of currencies that circulate

widely outside the country of issue. The index weights are derived from US export

shares and from US and foreign import shares.

12

To get the value of the basket of foreign currencies in US dollars, we multiply the

FX index by 1. We will relax the assumption that all positions are long in Section 4.2.

C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566 59

provides consistent estimates for a broad class of return densities. In

order to interpret these results one needs to recall that a positive

diversication differential would imply that the bank underesti-

mates the diversication effect.

The most important results in Fig. 3 are as follows. First, our two

correlation estimation strategies provide consistent results. Second

and most importantly, there is no systematic underestimation of

the diversication effect in our sample. The diversication differ-

ential is modest for most sample banks, sometimes being positive

and sometimes negative. There are two notable exceptions though.

The rst one concerns the diversication assumed by Bank of

America between 2001 and 2004. During this period, there is a

negative differential which suggests that the bank exaggerated

its diversication effect. This nding clearly contradicts the diver-

sication hypothesis. Another interesting episode covers the quar-

ters between 2004-Q1 and 2005-Q1 during which HSBC virtually

neglected the correlations among risk categories (as already noted

in Fig. 2).

We note that the gap between the actual and empirical diversi-

cation measures is smaller for Citigroup and JPMorgan Chase than

for Bank of America and HSBC. Indeed the average absolute differ-

ence between d and d

E

(computed from unconditional correlations)

is 5.7% and 5.2% for the rst two banks and 9.5% and 13.2% for the

later two. For each bank and each quarter, we compute the ratio of

Trading Assets to Total Assets from their consolidated nancial

statements (FR Y-9C form). It turns out that these two groups of

banks differ dramatically in terms of trading activity. Trading as-

sets constitute between 20% and 30% of the total assets for Citi-

group and JPMorgan Chase but only between 10% and 13% for

Bank of America and HSBC, which is close to the average level in

the US (see Hirtle, 2007). Although anecdotal, this evidence sug-

gests that banks with large trading operations are particularly

careful when handling the correlation structure of their trading

portfolio.

The main nding of our empirical analysis is that VaR over-

reporting does not seem to be consistently due to a partial diversi-

cation adjustment. An important implication of our main result is

that individual VaRs are inated or, in other words, that banks dis-

closures do not reect accurately the exposures of their trading

books with respect to the main sources of risk in the economy.

4. Robustness checks and extensions

4.1. Risk index selection

We rst check the sensitivity of out empirical results to the

choice of the risk proxies. To do so, we nd for each source of risk

an alternative daily time series. The new indices are the follow-

ing: for equity, Dow Jones Wilshire 5000 Composite (source:

Datastream); for interest rate, the 3-year treasury yield (source:

FRED); for commodity, the S&P GSCI Commodity Total Return

(source: Datastream); for credit spread, the difference between

the yield on BAA 20-year corporate bonds and the 20-year trea-

sury yield (source: FRED); and for FX, the broad Trade-Weighted

Exchange Index for the value of the USD computed by the Board

of Governors (source: Federal Reserves website). The equity,

interest rate, and commodity indices are available over the entire

sample period (January 1991March 2007), whereas the FX and

credit spread series started in January 1995 and October 1993,

respectively.

As a robustness check for our choice of risk proxies, we vary

each one-by-one and re-estimate the DCC model with the one

new risk proxy using the longest common sample period. We com-

pute the diversication coefcient for each bank and compare it to

its value computed using the original dataset. We nd that the

average absolute difference in the percentage diversication re-

mains always below 5% for all bank/index. For instance, the aver-

age absolute difference in the diversication coefcient for

JPMorgan Chase is 3.06% for interest rate, 2.18% for equity, 2.34%

for FX, 0.79% for commodity, and 1.74% for credit spread. Given

the stability of the results, we will be using the original sample

in the rest of the study.

4.2. Allowing for short positions

Thus far, we have assumed that banks have long net positions in

all asset classes. However it is conceivable that some net positions

could be short. We re-run our analysis assuming that our sample

banks have a short net position in credit spread (left panels of

Fig. 4) or in FX (right panels of Fig. 4). Note that introducing a short

position is simply done by multiplying by 1 the risk index used in

Table 2

DCC parameter estimates.

Interest rate Equity FX Commodity Credit spread

x 100 0.8554 0.5219 0.0916 0.2461 2.0170

s.e. (0.4016) (0.2704) (0.1408) (0.0973) (1.0984)

a 0.0648 0.0522 0.0350 0.0571 0.0894

s.e. (0.0186) (0.0105) (0.0127) (0.0111) (0.0268)

b 0.9315 0.9435 0.9602 0.9423 0.9056

s.e. (0.0187) (0.0115) (0.0206) (0.0109) (0.0282)

Correlation matrix (R)

Interest rate 1.0139 0.0151 0.1392 0.0512 0.4263

Equity (0.0229) 0.9927 0.0652 0.0130 0.1026

FX (0.0175) (0.0174) 0.9935 0.1228 0.0782

Commodity (0.0162) (0.0161) (0.0164) 0.9853 0.0228

Credit spreads (0.0190) (0.0193) (0.0172) (0.0157) 0.9984

Parameter s.e.

h

1

0.0162 (0.0018)

h

2

0.9789 (0.0027)

Notes: This table presents the coefcient estimates for the Dynamic Conditional Correlation. The returns are assumed to be multivariate normal with a conditional covariance

matrix H

t

= E(et e

/

t

) = D

t

R

t

D

t

, where D

t

is a diagonal matrix of conditional standard deviations that are modeled as univariate GARCH models: D

2

t

=

diag(x

i

) diag(a

i

) (r

t1

r

/

t1

) diag(b

i

) D

2

t1

, where denotes the Hadamard multiplier, and R

t

is the conditional correlation matrix. The correlation matrix is expressed as

R

t

= diag(Q

t

)

1/2

Q

t

diag(Q

t

)

1/2

and the matrix Q

t

is modeled as a GARCH-type function of the lagged standardized residuals zt = D

1

t

rt that depends on only two scalar

parameters h

1

and h

2

: Q

t

= R(1 h

1

h

2

) + h

1

(z

t1

z

t1

) + h

2

Q

t1

and R is the unconditional sample correlation matrix of the standardized residuals. The parameters that drive

the conditional variance dynamics are estimated by maximizing the N univariate GARCH log-likelihoods and then conditioning on the volatility dynamics estimate the

correlation parameters. Robust standard errors (s.e.) are displayed in parenthesis (for the correlation coefcients standard error is reported below the principal diagonal).

60 C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566

the all-long case. Interestingly, we nd that our main conclusion

is robust to these alternative weighting schemes. Indeed, the over-

all pattern of d

E

d is generally preserved for both the historical

correlation and DCC approaches. Of particular interest are the re-

sults for Bank of America since the trading portfolio of this bank

is particularly exposed to credit spread (see Fig. 1). For this bank,

d is always larger than d

E

when the credit spread position is as-

sumed to be short, which clearly contradicts the diversication

hypothesis.

4.3. BEKK model

Another robustness check is to consider an alternative econo-

metric model for the correlation structure among risk indices.

The BEKK model of Baba et al. (1990) and Engle and Kroner

(1995) was introduced as an easy way to ensure the covariance

matrices are well dened. The covariance dynamics is:

H

t

= CC

/

A(e

t1

e

/

t1

)A

/

BH

t1

B

/

; (11)

JPMorgan Chase : E -

-50%

-30%

-10%

10%

30%

50%

Citigroup : E -

-50%

-30%

-10%

10%

30%

50%

HSBC : E -

-50%

-30%

-10%

10%

30%

50%

Bank of America : E -

-50%

-30%

-10%

10%

30%

50%

JPMorgan Chase : DCC E -

-50%

-30%

-10%

10%

30%

50%

Citigroup : DCC E -

-50%

-30%

-10%

10%

30%

50%

HSBC : DCC E -

-50%

-30%

-10%

10%

30%

50%

Bank of America : DCC E -

-50%

-30%

-10%

10%

30%

50%

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

Fig. 3. Comparing actual and empirical diversication. Note: This gure displays the difference between d the actual diversication coefcient (shown in Fig. 2) and d

E

an

empirical estimate of the diversication coefcient estimated from banks individual VaRs and market indices. For each sample bank and each quarter, the empirical

diversication coefcient is given by one minus the ratio of the empirical VaR and the sum of the banks individual VaRs. In the left panels, we estimate the empirical VaR

using an historical estimate of the correlation matrix among risk category indices. In the right panels, we estimate the empirical VaR tting the Dynamic Conditional

Correlation model of Engle (2002) to the risk category indices.

C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566 61

which is guaranteed to be positive semi-denite by construction.

We assume that the matrices A and B are diagonal to make estima-

tion feasible. The parameters of the model are estimated by quasi-

maximum likelihood and reported in Table 3. For each bank/quar-

ter, we estimate the empirical diversication coefcient d

E

using

the results from the BEKK model. Then we plot in the left panels

of Fig. 5 the value of the diversication differential d

E

d for all

banks. Our main conclusion is not materially altered by the use of

this alternative covariance dynamics.

4.4. Time-varying copula model

Our empirical results to date use a very simple approach to

compute the diversication effect in Eq. (4) using only the correla-

tion matrix. Unfortunately this elegant approach is only valid if re-

turns are from the elliptical family of distributions such as the

multivariate normal or t. This assumption is limiting, as the multi-

variate elliptical family requires that the marginal standardized

densities for all assets are identical. For example, if the vector of

JPMorgan Chase : DCC E -

(Credit Spread SHORT)

-50%

-30%

-10%

10%

30%

50%

Citigroup : DCC E -

(Credit Spread SHORT)

-50%

-30%

-10%

10%

30%

50%

HSBC : DCC E -

(Credit Spread SHORT)

-50%

-30%

-10%

10%

30%

50%

Bank of America : DCC E -

(Credit Spread SHORT)

-50%

-30%

-10%

10%

30%

50%

JPMorgan Chase : DCC E -

(FX SHORT)

-50%

-30%

-10%

10%

30%

50%

Citigroup : DCC E -

(FX SHORT)

-50%

-30%

-10%

10%

30%

50%

HSBC : DCC E - (FX SHORT)

-50%

-30%

-10%

10%

30%

50%

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

Bank of America : DCC E -

(FX SHORT)

-50%

-30%

-10%

10%

30%

50%

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1 01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

Fig. 4. Comparing actual and empirical diversication with short positions. Note: This gure displays the difference between d the actual diversication coefcient (shown in

Fig. 2) and DCC d

E

an empirical estimate of the diversication coefcient estimated from banks individual VaRs and market indices. For each sample bank and each quarter,

the empirical diversication coefcient is given by one minus the ratio of the empirical VaR and the sum of the banks individual VaRs. In all panels, we estimate the empirical

VaR tting the Dynamic Conditional Correlation model of Engle (2002) to the risk category indices. In the left (respectively right) panels, we assume that the bank net

aggregate position in credit spread (FX) is short, whereas all other net aggregate positions are assumed to be long.

62 C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566

returns r is multivariate t (which is a member of the elliptical fam-

ily) then all the individual returns must have the same degrees of

freedom. Rather than restrict ourselves to the elliptical family we

can model the joint distribution of returns using the copula ap-

proach. A copula is a function that enables N different marginal

densities to be coupled together to form a multivariate density:

F(r

1

; r

2

; . . . ; r

n

) = C(F

1

(r

1

); . . . ; F

n

(r

n

)); (12)

where the function C is a cumulative density function with uniform

marginals. Similarly, and most useful to our application, a density

can be expressed as a function of the marginals and the density cop-

ula c:

f (r

1

; r

2

; . . . ; r

n

) =

n

i=1

f

i

(r

i

)

_ _

c(F

1

(r

1

); . . . ; F

n

(r

n

)): (13)

The multivariate Gaussian Copula is dened as:

c(u

1

; . . . ; u

n

; R) =

/

n

(U

1

(u

1

); . . . ; U

1

(u

n

); R)

n

i=1

/(U

1

(u

i

))

; (14)

where /

n

(z

1

; . . . ; z

n

; R) denotes the probability function of an n-

dimensional multivariate normal random vector with correlation

matrix R and z

it

= U

1

(u

it

) = U

1

(F

i

(r

it

)) is the normal quantile of

the probability integral transform of model i, and can be thought

of as a pseudo-standardized residual. If the conditional density is

correctly specied the probability integral F

i

(r

it

) will be indepen-

dent uniform random variables, and then z

it

will be independent

standard normal random variables. The key benet here is that

the marginal densities f

i

(and hence marginal distributions F

i

) can

be specied independent of each other. For example, we can allow

for symmetric Student t distributions with different degrees of free-

dom or even allow, as we do in the sequel, for asymmetry (see Pat-

ton, 2006; Jondeau and Rockinger, 2006; Bali et al., 2008; Bartram

et al., 2007). As in Section 2, we model the dynamics of R

t

using

the correlation dynamics used in the DCC model of Engle

(2002).

13

The difculty we now face is that the distribution of a port-

folio is not known in closed form, which complicates computing the

DVaR. Recall that assuming zero expected returns we can express the

VaR as in Eq. (1) as VaR

i

= j

i

r

i

x

i

though in our case the scaling coef-

cient j

i

will vary across risk indices. We can recover x

i

from the

conditional variance and shape parameters of the conditional distri-

bution along with the VaR

i

, giving:

x

i

=

VaR

i

r

i

j

i

; (15)

where r

i

j

i

is the VaR of a $1 investment in index i. We can then

compute that implied DVaR by simulating the returns of a portfolio

with investment weights x

i

for i = 1, . . . , N. To do this, we take the

conditional correlation coefcient R

t

describing the shape of the

conditionally normal copula and generate the N-vector of returns:

y

(k)

t

= R

1=2

t

z

(k)

(16)

for i.i.d. standard normal z, and R

1=2

t

denotes the Cholesky factoriza-

tion of the correlation matrix. We then compute the percentiles

u

(k)

it

= U(y

(k)

it

) and simulate the portfolio returns by computing the

conditional percentiles based on the empirical model for the mar-

ginal distributions r

(k)

it

= F

1

it1

(y

(k)

it

), where F

1

it1

denotes the inverse

cumulative density function or quantile function conditional on

information available at time t-1 for risk index i. We then compute

the hypothetical return on the portfolio as:

r

(k)

pt

= x

/

t

r

(k)

t

; (17)

where r

(k)

t

= r

(k)

it

; i = 1; . . . ; n is the vector of index returns. The VaR

is computed as the empirical quantile across the simulated hypo-

thetical portfolio returns.

We model the marginal distribution of each factor return as a

GARCH(1, 1) process where the standardized distributions are ta-

ken from the Skewed-t distribution of Hansen (1994):

h

it

= x

i

a

i

e

2

i;t1

b

i

h

i;t1

; (18)

where z

it

= e

it

=

h

it

_

- Skewt(k; g) and 1 6 k 6 1 is the asymme-

try parameter and 2 < g denotes the degrees of freedom. The prob-

ability density function of the Skewed-t random variable is given

by:

f (z; k; g) =

bc 1

1

g2

bza

1k

_ _

2

_ _

(g1)=2

; z < a=b;

bc 1

1

g2

bza

1k

_ _

2

_ _

(g1)=2

; z _ a=b;

_

_

(19)

where

a = 4kc

g 2

g 1

_ _

; b

2

= 1 3k

2

a

2

; c =

C

g1

2

_ _

p(g 2)

_

C

g

2

_ _ :

The distribution can generate both skewness and kurtosis and

the symmetric Student t distribution when k = 0 and nests the nor-

mal distribution when g

1

= 0. Because we have used the Gaussian

copula we nest the DCC model when g

1

= 0.

Table 3

BEKK parameter estimates.

Interest rate Equity FX Commodity Credit spread

A 0.2270 0.1690 0.1668 0.2428 0.2303

s.e. (0.0308) (0.0609) (0.0204) (0.0255) (0.0358)

B 0.9718 0.9841 0.9696 0.9478 0.9709

s.e. (0.0075) (0.0121) (0.0093) (0.0101) (0.0090)

(CC

/

) * 100

Interest rate 1.0174

(0.4405)

Equity 0.0589 0.3299

(0.0779) (0.4015)

FX 0.1339 0.0575 0.5206

(0.0568) (0.0380) (0.2058)

Commodity 0.1929 0.0572 0.1027 2.8271

(0.1042) (0.0699) (0.0495) (0.8303)

Credit spreads 0.7722 0.0801 0.0451 0.1524 1.2988

(0.3558) (0.0778) (0.0401) (0.1091) (0.6324)

Notes: This table presents the coefcient estimates for the BEKK model. The covariance dynamics is Ht = CC

/

A(e

t1

e

/

t1

)A

/

BH

t1

B

/

, where A and B are diagonal matrices

and CC

/

is a symmetric matrix. The model is estimated by quasi-maximum likelihood. The robust standard errors (s.e.) are displayed in parenthesis.

13

As a robustness check, we have constructed the correlation matrix on the basis of

Pearsons correlation, pair-wise Spearmans correlation, and Kendalls tau. The results

were not materially affected.

C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566 63

Table 4 reports the parameter estimates. The dynamics of both

the conditional volatility and the correlation matrix of the pseudo-

standardized residuals are quite similar in both the Copula and the

DCC models (though volatility in the Copula model responds

slightly less to innovations in returns than in the DCC model). This

suggests that accounting for skewness and excess kurtosis does not

materially affect the volatility dynamics. We also note that there is

clear variation in degrees of freedom across the risk indices. Then,

we plot in the right panels of Fig. 5 the value of the diversication

differential d

E

d. The diversication effect obtained using Copula

model is very similar to the two multivariate GARCH-based esti-

mates, and provides no support for the claim that banks systemat-

ically understate the diversication effect.

5. Conclusion

A reason often put forward in the literature to explain banks

VaR overstatement is a systematic underestimation of the diversi-

cation among broad risk categories (see Berkowitz and OBrien,

2002; Prignon et al., 2008). An implication of the diversication

hypothesis is that, although aggregate VaRs are inated risk mea-

sures, individual VaRs may be unbiased and as a result, are useful

JPMorgan Chase : BEKK E -

-50%

-30%

-10%

10%

30%

50%

Citigroup : BEKK E -

-50%

-30%

-10%

10%

30%

50%

HSBC : BEKK E -

-50%

-30%

-10%

10%

30%

50%

Bank of America : BEKK E -

-50%

-30%

-10%

10%

30%

50%

JPMorgan Chase : Copula E -

-50%

-30%

-10%

10%

30%

50%

Citigroup : Copula E -

-50%

-30%

-10%

10%

30%

50%

HSBC : Copula E -

-50%

-30%

-10%

10%

30%

50%

Bank of America : Copula E -

-50%

-30%

-10%

10%

30%

50%

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

01Q4 02Q3 03Q2 04Q1 04Q4 05Q3 06Q2 07Q1

Fig. 5. Comparing actual and empirical diversication (BEKK and Copulas). Note: This gure displays the difference between d the actual diversication coefcient (shown in

Fig. 2) and d

E

an empirical estimate of the diversication coefcient estimated from banks individual VaRs and market indices. For each sample bank and each quarter, the

empirical diversication coefcient is given by one minus the ratio of the empirical VaR and the sum of the banks individual VaRs. In the left panels, we estimate the

empirical VaR tting a BEKK model of Engle and Kroner (1995) to the risk category indices. In the right panels, we estimate the empirical VaR using a copula-based model.

64 C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566

to market participants. Contrary to the diversication hypothesis,

we nd that commercial banks make signicant adjustments to

their VaR to reect diversication effects, i.e., the average diversi-

cation effect is around 40%. Furthermore, we show that our sam-

ple banks handle their correlation structure quite well. This

conclusion is robust to the use of alternative risk proxies, correla-

tion models, and distributional assumptions. A consequence of our

nding is that individual VaRs, just like aggregate VaRs, are biased

risk assessments.

Although we study the aggregation process of risk-category

individual VaRs into a single rm-level VaR, an alternative strategy

would be to break-down VaR by trading line and to study the

diversication effect among them. Berkowitz et al. (forthcoming)

propose a promising attempt along this line.

Acknowledgements

This paper was originally submitted to Professor Giorgio Szego

on September 20, 2007 and was revised once prior to submission

through EES. We thank two anonymous referees for their com-

ments and Jiawen Lin and Yannan Qin for their help in constructing

the dataset. Part of this paper was written while Daniel Smith was

visiting the Queensland University of Technology. We are grateful

to the Social Sciences and Humanities Research Council of Canada

for their nancial support.

Appendix A. Portfolio VaR with elliptical distributions

The density of an elliptical distribution, if it exists, can be writ-

ten as a scalar function of the quadratic form (X l)

/

W

1

(X l),

and in particular:

f (X) = K[W[

1=2

g((X l)

/

W

1

(X l)); (A1)

where K is a normalizing constant and the scalar function

g : R

#R

these density functions are ellipsoids. Prominent examples of this

class of distributions are the multivariate normal and t distributions.

In the elliptical class, the mean and covariance matrix (if they

exist) are given by E(X) = l and V(x) = aW for some distribution

specic constant scalar a. For instance, for the multivariate normal

distribution we have a = 1 and for the multivariate t distribution

with g degrees of freedom we have a = (g 2)/g. If X is elliptical

then both linear transformations and the marginals are afne

too: if X - e(l; W) then Y = WX - e(Wl; WWW

/

), where W is an

mn matrix of rank m6 n. One useful implication of this result

is that each of the marginal distributions has the same distribution

as the marginal (e.g., if X is multivariate t with g degrees of free-

dom then all of the marginals are univariate t with g degrees of

freedom), which can be seen by setting W = e

i

and e

i

is the ith col-

umn of an n-dimensional identity matrix. This class of distributions

is also a member of the location-scale family, so the individual

VaRs can be expressed (assuming zero expected trading revenues)

as afne functions of the square root of the diagonal elements of W.

Given that W= cV, where c = 1/a is a density-dependent constant,

then we can write it as W= cDRD and the entire analysis leading

to Eq. (2) goes through.

We can go one step further and point out that as long as the

conditional covariance matrix and mean are correctly specied,

then maximizing the Gaussian log-likelihood as we do above will

render consistent estimates regardless of the true distribution.

Assuming the banks compute their VaR using the implied model

then we can account for the diversication effect using the Gauss-

ian-based conditional correlation coefcient and this will be

appropriate for any of the elliptical class of densities. This is partic-

ularly important given the popularity of the multivariate t density

for asset pricing tests and portfolio selection (see Owen and Rabi-

novitch, 1983).

References

Baba, Y., Engle, R.F., Kraft, D., Kroner, F., 1990. Multivariate Simultaneous

Generalized ARCH. Working Paper, University of California, San Diego.

Bakshi, G., Panayotov, G., 2007. The Capital Adequacy Puzzle. Working Paper,

University of Maryland.

Bali, T.G., Mo, H., Tang, Y., 2008. The role of autoregressive conditional skewness and

kurtosis in the estimation of conditional VaR. Journal of Banking and Finance 32,

269282.

Bartram, S., Taylor, S.J., Wang, Y., 2007. The Euro and European nancial market

dependence. Journal of Banking and Finance 31, 14611481.

Basel Committee on Banking Supervision, 1996. Amendment to the Capital Accord

to Incorporate Market Risks. Bank for International Settlements.

Berkowitz, J., Christoffersen, P.F., Pelletier, D., forthcoming. Evaluating Value-at-Risk

models with desk-level data. Management Science.

Table 4

Copula parameter estimates.

Interest rate Equity FX Commodity Credit spread

x 100 0.3696 0.3066 0.0525 0.2380 1.7603

s.e. (0.1680) (0.1394) (0.0471) (0.0920) (0.7730)

a 0.0397 0.0481 0.0381 0.0522 0.0783

s.e. (0.0070) (0.0089) (0.0088) (0.0112) (0.0213)

b 0.9575 0.9499 0.9602 0.9465 0.9167

s.e. (0.0074) (0.0094) (0.0100) (0.0109) (0.0223)

~

k

a

0.0312 0.0747 0.0794 0.0715 0.0777

s.e. (0.0335) (0.0381) (0.0415) (0.0439) (0.0416)

g

1

0.2163 0.1386 0.1309 0.1048 0.1735

s.e. (0.0126) (0.0155) (0.0144) (0.0148) (0.0148)

Correlation matrix

Interest rate 1.0279 0.0291 0.1356 0.0567 0.3961

Equity (0.0183) 0.9961 0.0704 0.0113 0.0902

FX (0.0170) (0.0166) 0.9927 0.1205 0.0763

Commodity (0.0161) (0.0159) (0.0161) 0.9848 0.022

Credit spreads (0.0174) (0.0169) (0.0165) (0.0157) 0.9967

Parameter s.e.

h

1

0.0160 (0.0015)

h

2

0.9801 (0.0021)

Notes: This table presents the coefcient estimates for the copula-based model.

a

To ensure 1 < k < 1, we estimate a monotonic transformation that is dened over the whole real line,

~

k = log[(1 k)=(1 k)[, where

~

k is dened as the extended logistic

transformation of k. The robust standard errors (s.e.) are displayed in parenthesis. For the correlation coefcients, standard errors are reported below the principal diagonal.

C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566 65

Berkowitz, J., OBrien, J., 2002. How accurate are value-at-risk models at commercial

banks? Journal of Finance 57, 10931111.

Berkowitz, J., OBrien, J., 2007. Estimating bank trading risk: A factor model

approach. In: Carey, M., Stulz, R.M. (Eds.), The Risk of Financial Institutions.

University of Chicago Press, Chicago.

Breuer, T., Jandacka, M., Rheinberger, K., Summer, M., forthcoming. Does adding up

of economic capital for market- and credit risk amount to conservative risk

assessment? Journal of Banking and Finance.

Danielsson, J., Zigrand, J., 2006. On time-scaling of risk and the square-root-of-time

rule. Journal of Banking and Finance 30, 27012713.

Engle, R.F., Kroner, K.F., 1995. Multivariate simultaneous generalized ARCH.

Econometric Theory 11, 122150.

Engle, R.F., 2002. Dynamic conditional correlation a simple class of

multivariate GARCH models. Journal of Business and Economic Statistics

20, 339350.

Hansen, B.E., 1994. Autoregressive conditional density estimation. International

Economic Review 35, 705730.

Hirtle, B., 2003. What market risk capital reporting tells us about bank risk. FRBNY

Economic Policy Review (September), 3754.

Hirtle, B., 2007. Public Disclosure, Risk, and Performance at Bank Holding

Companies. Working Paper, Federal Reserve Bank of New York.

Jondeau, E., Rockinger, M., 2006. The copula-GARCH model of conditional

dependencies: An international stock market application. Journal of

International Money and Finance 25, 827853.

Jorion, P., 2002. How informative are value-at-risk disclosures? Accounting Review

77, 911931.

Jorion, P., 2006. Value at Risk: The New Benchmark for Managing Financial Risk,

third ed. McGraw-Hill.

Owen, J., Rabinovitch, R., 1983. On the class of elliptical distribution and their

applications to the theory of portfolio choice. Journal of Finance 38, 745752.

Patton, A.J., 2006. Modelling asymmetric exchange rate dependence. International

Economic Review 47, 527556.

Prignon, C., Deng, Z.Y., Wang, Z.Y., 2008. Do banks overstate their value-at-risk?

Journal of Banking and Finance 32, 783794.

Prignon, C., Smith, D.R., forthcoming. The level and quality of Value-at-Risk

disclosure by commercial banks. Journal of Banking and Finance.

Pritsker, M., 2006. The hidden dangers of historical simulation. Journal of Banking

and Finance 30, 561582.

66 C. Prignon, D.R. Smith/ Journal of Banking & Finance 34 (2010) 5566

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