Measuring Market Risk Philippe Jorion

Measuring Market Risk

VAR
Philippe Jorion
University of California at Irvine
July 2004
Please do not reproduce
without authors permission
2004 P.Jorion
E-mail: pjorion@uci.edu
411-ecs60931.swf; VARstart.swf
Philippe Jorion
Measuring Market Risk:

PLAN
(1) Risk factors and mapping
(2) Approaches to VAR
(3) Modeling time-variation in risk
(4) The Basel Internal Model Approach

(1)
Risk Factors and Mapping
Philippe Jorion
Principles of
Market Risk Measurement
Objective: Obtain a good estimate of
portfolio risk at a reasonable cost
! Steps:
!
(1) choose a set of elementary risk factors and

estimate their probability distribution
(2) mapping: decompose financial instruments
into exposures on these risk factors
(3) aggregate the exposure for all positions and
build the distribution of P&L on portfolio
Risk Management - Philippe Jorion
Risk Decomposition:
The Theory of Particle Finance
!
Define risk factors

bonds: first factor is yield change (duration model)
stocks: first factor is market (diagonal model)
forward contract: factor is spot exchange rate and
interest rates
Decompose all positions as exposures on risk

factors
! Aggregate all exposures across the portfolio
! Assess possible movements in risk factors
! Reconstruct risk of total portfolio
!
Philippe Jorion
Mapping in Risk Measurement
424-ecs41433.swf; VARmapping.swf
Mapping in Risk Measurement

Instruments
#1
#2
#3
#4
#5
#6
Risk
Factors
#1
#2
#3
Risk Aggregation
Philippe Jorion

(2)
Approaches to VAR
Approaches to VAR
Risk Measurement
Local Valuation
Methods
Linear
Models
Full Valuation
Methods
Quadratic
Models
Monte Carlo
Simulations
Historical
Simulations
Philippe Jorion
Approaches to VAR:
Local versus Full Valuation
In general, the portfolio value is a non-linear
function of risk factors V=V(S)
! Local valuation:
!
price the portfolio at current position and

V
compute local derivatives V0, 0 =
linear approximation: dV = 0 dS
simple and fast
!
Full valuation:
reprice portfolio: dV = V(S1)-V(S0)
much more time intensive
Local Valuation Method

Replaces all positions
by a portfolio of delta
(linear) exposures on
risk factors
! Assumes risk factors
have normal distribution
! Portfolio risk obtained
from delta exposures
and covariance matrix
!
Philippe Jorion
424-ecs?.swf; VARlocal.swf
Local Valuation Method

Replaces all positions
by a portfolio of delta
(linear) exposures on
risk factors
! Assumes risk factors
have normal distribution
from delta exposures
and covariance matrix
!
Payoff
0
V(S0 )
S0
Risk Factor
Full Valuation Method

Reprices all positions
under new values for
risk factors
! Assumes a distribution
for risk factors
from distribution of
portfolio values
!
Philippe Jorion
424-ecs?.swf; VARfull.swf
Full Valuation Method

Reprices all positions
under new values for
risk factors
! Assumes a distribution
for risk factors
from distribution of
portfolio values
!
Payoff
V(S1 )
V(S0 )
S1
S0
Risk Factor
Approaches to VAR
!
Delta-Normal
combines linear positions with covariances
Historical Simulation
replicates current portfolio over historical data
Monte Carlo Simulation

creates simulations of financial variables
Philippe Jorion
Example: We hold a position in a forward

contract to buy 10MM British pounds (BP) for
$16.5MM in three months. Based on the last
100 days, what is its 95%, 1-day VAR?
Plot:
Spot rate
Dollar interest rate
Pound interest rate
Historical Data
1.74
Day
1.72
100
100
1.70
Variable
1.68
Value
Spot rate ($/) =
Dollar rate (% pa) =
Pound rate (% pa) =
1.66
1.64
$1.6637
4.9375
5.9688
1.62
1.60
1.58
1.56
98/08/10
98/09/08
98/10/06
98/11/03
98/12/01
98/12/31
Day
Note: Change any of the inputs by entering a value or moving the scroll bar. Graph will automatically update.
Risk Management - Philippe JorionActionSetting:On Click, open object
SL 40:DATA sheet in bpforws.xls (paste as wks)
Approaches to VAR:
Delta-Normal
!
Assumptions:
returns are normally distributed
payoffs are linear in the risk factors
Method:
portfolio variance combines linear positions
with forecast of covariance matrix
p2 = wt t+1 wt
VAR = p W
Philippe Jorion
Delta-Normal Method:
Example of a Forward Contract
Forward
Contract
$16,392,393
$16,392,393
Risk
Factor #1:
Risk
Factor #2:
Risk
Factor #3:
Foreign
Currency Bond
Domestic
Currency Bond
Spot Price
-$16,298,812
Example
Confidence level (%)
Distribution of P&L
95
95%
Delta-normal VAR
Result =
$127,148
25
Normal
Frequency
20
15
VAR-Normal
10
0
-$200,000
-$100,000
$0
$100,000
$200,000
P&L
Note: Change any of the inputs b y entering a value or moving the scroll b ar. Graph will automatically update.
Philippe Jorion
SL 40:DeltaN sheet in bpforws.xls (paste as wks)
10
Pros and Cons
!
Advantages:
simple method
fast computation, even for large portfolios
can be extended to time-varying risk
easy to explain
Problems:
linear model: may mismeasure risk of options
relies on normal approximation: cannot explain
fat tails
Approaches to VAR:
Historical-Simulation
!
Assumptions:
recent historical data relevant
full valuation
Method:
use history of changes in risk factors yi
starting from current values, construct yt+yi ...
evaluate portfolio under simulated factor
compile distribution of portfolio changes
bootstrapping method
Philippe Jorion
11
Historical-Simulation Method:
Example
Day
=
Historical Simulation of P&L
10
$200,000
Portfolio return
Result =
$150,000
-$33,640
Profit and Loss
$100,000
$50,000
$0
-$50,000
-$100,000
-$150,000

=
VAR
-$200,000
98/08/10
98/09/08
98/10/06
98/11/03
98/12/01
98/12/31
Day
95%
95
VAR
Result
$119,905
SL 45:HistSim sheet in bpforws.xls (paste as wks)
Example
Distribution of P&L
95
95%
Frequency
25
20
VAR-HS
15
VAR-Normal
Historical
Normal
Historical-simulation VAR
Result =
$119,905
10
Delta-normal VAR
Result =
$127,148
0
-$200,000
-$100,000
$0
$100,000
$200,000
P&L
Note: Change any of the inputs by entering a value or moving the scroll bar. Graph will automatically update.
Philippe Jorion
SL 46:HistDist2 sheet in bpforws.xls (paste as wks)
12
Pros and Cons
!
Advantages:
accounts for non-normal data
full valuation method
easy to explain
Problems:
only one sample path, which may not be
representative
no time-variation in risk
Approaches to VAR:
Monte Carlo
!
Assumptions:
define joint stochastic model for risk factors
full valuation
Method:
use numerical simulations for risk factors to
horizon
value portfolio
report full portfolio distribution
Philippe Jorion
13
Monte Carlo Simulation Method:

Example
Simulated Risk Factor
Distribution of P&L
1.68
Frequency
1.67
1.66
1.65
0
-$200,000-$100,000
Tim e
$0
$100,000 $200,000
P&L
SL 48:MCSim sheet in bpforws.xls (paste as wks)
Monte Carlo Simulation Method:

Example
Distribution of P&L
95%
95
Monte Carlo
Frequency
VAR
Monte Carlo-simulation VAR

Result =
$132,669
Delta-normal VAR
Result =
-$200,000
-$100,000
$0
$100,000
$127,148
$200,000
P&L
Philippe Jorion
SL 49:MCHistDist2 sheet in bpforws.xls (paste as wks)
14
Monte Carlo Method:

Pros and Cons
!
Advantage:
most flexible method
appropriate for complex instruments
allows fat tails and time-variation in risk
Problems:
computational cost
most difficult to implement--intellectual cost
subject to model risk--wrong assumptions
subject to sampling estimation error
Approaches to VAR:
Comparison
Valuation
Delta-normal Historicalsimulation
Linear
Nonlinear
Distribution Normal,
Actual
Time-varying
Speed
Fastest
Fast
Pitfalls
Options,
Fat tails
Monte- Carlo
Nonlinear
General
Slow
Short sample Model risk,

Sampling error
Philippe Jorion
15
Approaches to VAR:
FSA Survey
MC
Simulation,
23%
Delta
Normal,
42%
Historical
Simulation,
31%

(3)
Modeling time variation in risk
Philippe Jorion
16
Time Variation in Risk

There is strong evidence that daily volatility
moves in a predictable fashion for most
financial series
! Risk measures can be adapted to model time
variation, based on historical data
! Time series models for volatility can also pick
up structural changes (e.g. transition from
fixed to flexible exchange rate system)
!
Volatility Estimation:
(1) Moving Average
!
Define the innovation as squared daily return

x(t) = R2t
Using a moving window of size N, the

variance forecast is:
ht =
1
N
N
i =1
Rt2 i
The volatility forecast is t = ht

! Recent large movements will increase the
variance forecast, as long as within the
window (but drop off after N)
!
Philippe Jorion
17
(2) Exponential Smoothing
!
The variance forecast is:

ht = (1 ) Rt21 + ht 1
conditional residual t=(Rt /t) is normal
recursive forecast: history summarized in h
Uses exponentially decaying weights:

ht = (1 )[ Rt21 + Rt2 2 + 2 Rt2 3 + ...]
weights on older observations decrease
EWMA = Exponentially Weighted Moving Average
Philippe Jorion
18
Weights on Previous Days: Daily Model

0.06
0.05
Exponential Model,
Decay=0.94
0.04
Moving Average Model,

Window=60
0.03
0.02
Exponential Model,
Decay=0.97
0.01
0
100
75
50
25
Days in the Past
EWMA
!
Benefits:
easy to implement--one parameter only
should lead to positive definite covariance matrix
special case of GARCH process--performs well
Estimation
example: JP Morgan RiskMetrics
choice of decay factor, =0.94 for all daily series
however, cannot be extended to longer horizons
Philippe Jorion
19
(3) GARCH Models
!
More general time-series model, with realistic

persistence in volatility
GARCH= Generalized Autoregressive Conditional
Heteroskedasticity
Typical GARCH(1) model:

ht = a0 + a1 Rt-12 + b ht-1
long-run forecast is h = a0 / (1-a1-b)
persistence parameter is (a1+b)
model can be extended to long horizon forecasts
describes well most financial time series
Volatility Forecasts: $/BP Exchange Rate

1.5 Daily volatility
GARCH Model
1
0.5
Exponential Model
0
1990
1991
1992
1993
1994
Philippe Jorion
20
Historical Simulation with

Time-Varying Volatility
Fit GARCH model to time series
! Construct scaled residuals t =(Rt /t)
! Apply historical simulation to scaled residual
and multiply by latest volatility forecast
! Example:
!
current t=1.5%
at t-20, Ri =1.6%, i =1%, i =1.6
forecast R*t = i t = 1.61.5% = 2.1%
repeat for all observations in the HS window
(See Hull and White, Journal of Risk, Fall 1998)
Capital Required for a Position of $1 in DM

0.5
0.4
HS: Historical Simulation using 500 most recent observations

BRW: Historical Simulation with exponential weights
HW: Historical Simulation with volatility changes
HS
BRW
HW
0.3
0.2
0.1
Jun-97
Dec-96
Jun-96
Dec-95
Jun-95
Dec-94
Jun-94
Dec-93
Jun-93
Dec-92
Jun-92
Dec-91
Jun-91
Dec-90
Jun-90
Dec-89
Source: Hull and White
Philippe Jorion
21
GARCH Models:
Technical Issues
Parameters need to be to estimated; risk of
overfitting the model in sample
! Too complex for multivariate systems
!
number of parameters increases geometrically

with number of series, for all variances and
pairwise covariances
covariance matrix needs to be positive definite
this is why RiskMetrics uses same parameter
for all series
!
Mean reversion is typically fast--not useful

for horizons above 1 month
Persistence in GARCH Model
Variance
Persistence parameter:
1
0.5
1.00
0.986
0.95
0.90
0.80
Initial shock
Average Variance
0
0 1
Philippe Jorion
10
15
20
25
Days ahead
22
Short- and Long-Term GARCH Forecast

1.5
Volatility forecast (%)
1-day
forecast
1
1-year
forecast
0.5
0
1990
1991
1992
1993
1994
GARCH Models:
Major Issues
Little evidence of predictability in risk over
longer horizons, e.g. beyond one month
! Using fast-moving GARCH system would
create capital charges that fluctuate too
much
! Basel Committee disallows GARCH models
(minimum window is one year)
!
Philippe Jorion
23

(4)
The Basel
Internal Model Approach
CAPITAL ADEQUACY:
Basel Market Rules
!
The computation of VAR shall be based on a

set of uniform quantitative inputs:
a horizon of 10 trading days, or two calendar weeks (T)

a 99 percent confidence interval (c)
an observation period based on at least a year of
historical data and updated at least once a quarter
Market Risk Charge is set at the higher of:
the previous day's VAR, and

the average VAR over the last sixty business days, times
a multiplier, k:
MRC(t) = Max[ k (1/60)i=160 VAR(t-i), VAR(t-1)]+SRC

Philippe Jorion
24
Internal Models:
Qualitative Criteria
!
Internal model can only be used when:

(a) banks have an independent risk control unit
(b) bank conducts back-testing
(c) board/senior management is involved
(d) internal model is used to monitor risk
(e) trading and exposure limits also exist
(f) stress testing is also used
(g) documentation for compliance exists
(h) independent reviews are done regularly
Internal Model:
The Multiplier
!
Multiplier: the value of k is determined by

local regulators, subject to a floor of three:
k is intended to provide additional protection

against unusual environments (otherwise, 1
failure very 4 years)
Plus factor: a penalty component shall be

added to k if back-testing reveals that the
bank's internal model incorrectly forecasts
risks, or internal risk management practices
are viewed as inadequate
Philippe Jorion
25
Why the Multiplicative Factor?

To protect against model risk, or fat tails
! For any random variable x with finite
variance, Chebyshevs inequality states
!
P[|x-|>r] 1/r2
if symmetric, P[(x-)<-r] (1/2)1/r2
set RHS to 1%; then r=7.071, VARMAX=7.071
with a normal distribution VARN=2.326
correction k= VARMAX/VARN=3.03
!
There is arbitrariness in the joint choice of

(c, T and k)
Internal Model:
Equivalent Risk Charges
Horizon:
1
2
5
10
Confidence
99.99%
5.9
4.2
2.7
1.9
99.9%
7.1
5.1
3.2
2.3
99%
9.5
6.7
4.2
3.0
97.5%
11.3 8.0
5.0
3.6
95%
13.4 9.5
6.0
4.2
90%
17.2 12.2 7.7
5.4
84.1%(1x) 22.1 15.6 9.9
7.0
Normal and independent distribution
20
60
250
1.3
1.6
2.1
2.5
3.0
3.9
4.9
0.77
0.92
1.22
1.45
1.73
2.22
2.85
0.38
0.45
0.60
0.71
0.85
1.09
1.40
Aaa
A3
Baa3
Ba3
B1
B2
B3
Philippe Jorion
26
VAR Reporting: 2003

Institution
Conf. 1-day VAR ($MM) MRC ($MM) Capital

LevelReported 99% General Actual ($MM)
US Commercial Banks
Bank of America
Citicorp
JP Morgan Chase
99
99
99
34
39
175
34
39
175
319
370
1,659
- 66,651
816 76,153
- 59,816
95
95
99
58
27
58
82
39
58
778
366
550
21,362
27,651
24,867
99
99
98
61
90
46
61
90
52
576
853
495
956 37,447
1,174 26,979
1,973 43,110
US Investment Banks
Goldman Sachs
Merrill Lynch
Morgan Stanley
Non-US Commercial Banks
Deutsche Bank
UBS
Barclays
(Annual average)
\var\wbank\var-annual.xls (paste as PIC)
Informativeness of VAR:
Realized and Forecast Risk (8 US Banks, 95.Q1-00.Q3)

$900
A bsolute value of unexpected trading revenue
$800
$700
$600
$500
$400
$300
$200
$100
$0
$0
$50
$100
$150
$200
$250
VAR -based risk forecast

Philippe Jorion
Jorion (2002), ``How Informative are Value-at-Risk Disclosures?,'' Accounting Review
27
The Puzzle of
Conservativeness of VAR Measures
Bank
Bank
Bank
Bank
Bank
Bank
1
2
3
4
5
6
Com pa rison of P&L Pe rcentile a nd VAR

Exceptions
P&L
VAR
Excess
99th Pc Me a n
of VAR Obs Exp Nb
Mea n
-1.78
-1.87
5% 569
6
3
-2.12
-2.26
-1.74
-23% 581
6
6
-0.74
-2.73
-4.41
62% 585
6
3
-3.18
-1.59
-5.22
228% 573
6
0
NA
-2.78
-5.62
102% 746
7
1
-0.78
-0.97
-1.72
77% 586
6
3
-5.80
Reported VARs are too large:

possibly because capital adequacy requirements
are not binding, or to avoid regulatory intrusion
Source: Berkowitz and O'Brien (2002), How Accurate are the Value-at-Risk Models at Commercial Banks, Journal of Finance
Philippe Jorion
28
(5) Conclusions
CONCLUSIONS (1)
Market risk measurement applies to largescale portfolio and requires simplifications
! Among major design choices are
(1) the choice and number of risk factors
(2) the choice of a local versus full valuation
method for the instruments
! These choices depend on the nature of the
portfolio and reflect tradeoffs between speed
and accuracy
!
Philippe Jorion
29
CONCLUSIONS (2)
The ultimate goal of risk measurement is to
understand risk better so as to manage it
effectively
! Risk management should not only prevent
losses, but add value to the decision process
! Tools such as marginal and component VAR
are integral to portfolio management
! Proper risk management requires competent
risk managers
!
References
!
!
!
!
Philippe Jorion is Professor of Finance at the Graduate

School of Management at the University of California at Irvine
Author of Value at Risk, published by McGraw-Hill in 1997,
which has become an industry standard, translated into 7
other languages; revised in 2000
Author of the Financial Risk Manager Handbook, published
by Wiley and exclusive text for the FRM exam; revised in
2003
Editor of the Journal of Risk
Some of this material is based on the online "market risk
management" course developed by the Derivatives Institute:
for more information, visit www.d-x.ca, or call 1-866-871-7888
Phone: (949) 824-5245
FAX: (949) 824-8469
Philippe Jorion
E-Mail: pjorion@uci.edu
Web: www.gsm.uci.edu/~jorion
30

Measuring Market Risk Philippe Jorion

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