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## Ying FAN2, Yiming WEI

Institute of Policy and Management,
Chinese Academy of Sciences, P.O.Box 8712, Beijing 100080, P.R. China

Abstract: This paper applied the new risk management tool---VaR methodology to stock market
in China. From the comparison between the predicted VaR and real return, the calculated results
are mostly satisfied with the confidence level at 95%.
Keywords: VaR methodology, Risk management, EWMA

1. Introduction
Financial risk management is always one of the important topics either in theory or in practice.
In the last 25 years, international financial market has developed greatly, and financial storms
have much influence on human’s entire economic behavior with the mode of over imagination.
In early 1990’s, a kind of new risk management methodology was developed, which is VaR
methodology. VaR methodology is becoming to be the international standard of risk
measurement [1-4].
VaR (Value at Risk) is the maximum amount we expect to lose over some target period. The
strict definition is described as following:

## Pr ob[R < R * ] = ∫−∞ f ( R)dR = 1 − c

R*
(1)

Denote R is the random variable to describe the return of portfolio, f R is the probability density
function, c as confidence level, so the probability that return is less than R* is:
VaR(absolute) = -R*W (2)
The definition of VaR has two types: absolute VaR and relative VaR. Absolute VaR represents
the maximum likely loss relative present position:
And the relative VaR represents the maximum likely loss relative expected return which is often
more convenient to deal with:
VaR(relative) = -R*W+µW (3)
Where, µ is the expected return, W is the position.
There are many methods to calculate VaR, which fit different market conditions, data set and
precision require. Generally, we can classify them into three types :

1
Partially supported by grants (No. 9012004) from Natural Science Foundation of Beijing
2
To whom all correspondence should be addressed: email: yfan@mail.casipm.ac.cn

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l Variance-covariance method
l Historical simulation method
l Monte Carlo simulation method
The detailed discussion about historical simulation method and Monte Carlo simulation method
is in conference . In view of reality of Chinese stock market, this paper select Variance-
covariance method to estimate VaR of stock market in China. Especially exponential weighted
moving average (EWMA) method was used and the related problem was solved. The following
will give the optimal decay factors in Shenzhen stock market and Shanghai stock market.
Furthermore, the daily VaR of the two markets was forecasted on the real data.
2. EWMA method to estimate VaR
Denote {rt }is a time series of return of a certain financial instrument. On the hypothesis of
random walk, rt are normal distributed with mean µ and variance σt2.
rt ~ N ( µ, σt2 ) (4)
For return of every day, often assume µ=0  For a certain confidence level c, its correspondent
quartile in standard normal distribution is α, we can derive
VaR relative = - α σt W (5)
When portfolio holds two or over two kinds of assets, their correlation coefficient must be
calculated. What about portfolio of asset is not included in this paper.
In formula (5), W is the position of portfolio what is known at certain time t. α is determined by
confidence level c. So, When we estimate VaR with Variance-covariance method, the main
question is how to estimate the standard derivation of return distribution which is a measurement
of volatility.
From formula (4), we can use historical observation of rt to estimate σt, formula (6) is the

1 t 2
σˆ t = ∑ ri
T i =t −T +1
(6)

## estimation of using historical data length T:

This method to estimate variance is called simple moving average model (SMA). Its
characteristics are putting fixed equal weights for every data (1/T). So the result would be depend
on the selection of length T remarkably.
One improved model for SMA is EWMA, which weights are different for every observation, the
latest observation carry the highest weight in the volatility estimation.

σˆ t = (1 − λ)∑λi rt −i
2
(7)
i =0

In formula (7), the parameter λ (0 < λ <1) is often referred to as the decay factor. This parameter
determines the relative weights that are applied to the observations (returns) and the effective
amount of data used in estimating volatility.

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When we estimate volatility, we pay attention to three important issues that arise.
2.1 Acuracy of estimating ___ the calculating of tolerance level
Since 1-λ λi→0 (i →+∞)as the weight of rt −i , the estimation of volatility can be calculated
2

## proximately in limited sample length K. To that, define tolerance level LK.

LK = (1 − λ )∑ λi (8)
i=K

## In tolerance level LK, proximate estimation of standard derivation is

K −1
σˆ t = (1 − λ )∑ λi rt −i
2
(9)
i =0

(1 − λ )∑ λi = 1 (10)
i =0

## 2.2 The effective data length

From

LK = λ K (1 − λ )∑ λi = λ K (11)
i =0

We can transform formula (8) for (11).So, we know the relationship between decay factor λ,
effective amount of data K and tolerance level LK.

## 2.3 Determining the decay factor

The important problem is: how to determine the decay factor. Now, if we define the variance
forecast error as εt+1|t= rt+12- σt+1|t2, it then follows that the expected value of the forecast error is
zero, i.e., E εt+1|t =E rt+12 -σt+1|t2=0. Based on this relation a natural requirement for choosing λ
is to minimize average squared errors which is given by

1 T 2
RMSE = ∑
T t =1
(rt +1 − σˆ t2+1|t (λ))2 (12)

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Where, T is the days of prediction period.
Based on above RMSE criteria, J. P. Morgan have given some optimal decay factors of daily
VaR predicting for some financial instruments of some country in a technique document named
RiskMetrices, see table 1.

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Table 1 Optimal decay factors based on volatility forecasts
country Foreign 5-year swaps 10-year zero Equity indices 1-year money
exchange prices market rates
Austria 0.945 - - - -
Australia 0.980 0.955 0.975 0.975 0.970
Belgium 0.945 0.935 0.935 0.965 0.850
Canada 0.960 0.965 0.960 - 0.990
Switzerland 0.955 0.835 - 0.970 0.980
Germany 0.955 0.940 0.960 0.980 0.970
Denmark 0.950 0.905 0.920 0.985 0.850
Spain 0.920 0.925 0.935 0.980 0.945
France 0.955 0.945 0.945 0.985 -
Finland 0.995 - - - 0.960
Great Britain 0.960 0.950 0.960 0.975 0.990
Hong Kong 0.980 - - - -
Ireland 0.990 - 0.925 - -
Italy 0.940 0.960 0.935 0.970 0.990
Japan 0.965 0.965 0.950 0.955 0.985
Netherlands 0.960 0.945 0.950 0.975 0.970
Norway 0.975 - - - -
New Zealand 0.975 0.980 - - -
Portugal 0.940 - - - 0.895
Sweden 0.985 - 0.980 - 0.885
Singapore 0.950 0.935 - - -
United States - 0.970 0.980 0.980 0.965
ECU - 0.950 - - -
From table 1, we know decay factors of different instruments in different countries are very
different. It imply in certain country in certain background of economy and culture, the market
memory length for every instrument is different. In RiskMetrices, Shenzhen and Shanghai stock
markets in China were not included in.
3. VaR estimation of stock market in China based on EWMA method
For stock market in China, we estimate Value at Risk for every day. Denote Pt is the value of
index at time t, the time interval is 1 day. Suppose rt = ln Pt - ln Pt-1 , we use rt replace Rt.
We estimate VaR of Shanghai index and Shenzhen index with EWMA. The same period of
sample date are selected for convenient comparison from 1994.1.3 to 1998.1.23. The length of
data used for prediction is more than 1000 days, which implies the tolerance level is smaller than
0.001% when λ is greater than 0.85 according to formula (11). We got the result as following,

## Figure 1: Real Return and VaR in Shanghai

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chart 1 and chart 2 shows comparison between predicted VaR and real return.

## l The optimal λ for ShenZhen stock market reaches to 0.86.

l The optimal λ for Shanghai stock market reaches to 0.88.
l From the data of recent years, we know that the fluctuation of stock market of China is
large and the fluctuation of Shenzhen market is larger than that of shanghai market,
which is correspondence to the reality. The value of λ which was calculated with EWMA
method could better reflect the fluctuation of stock market of China and the memory
length of the markets.
l Applying the optimum decay factor λ, we use the EWMA method to predict the VaR of
Shanghai market and Shenzhen market and make their comparisons with real daily return
in the confidence level c=95%.
l We had forecasted VaR of Shenzhen index in the 475 days continually, and the results
show that the days in which the negative return over VaR is 28, the ratio is (28/475)=
5.89 %.
l At the same time, the result of Shanghai market show that the days in which the negative
return over VaR is 24 days, the ratio is (24 /475)=5.05%.
l From the comparison between the predicted VaR and real return, the calculated results
are mostly satisfied with the confidence level at 95%.
4. Remark
The study of this paper shows that VaR methodology can be applied to risk management in stock
market in China, which is efficient tool to measure market risk. There are much work should be
done for its widely application in the area of risk management of China besides stock market.

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Reference
 Z. WANG, G.TANG, S.SHI. VaR Methodology for financial risk analysis [J]. Chinese Journal of
Science.1999,51(6):15-18.
 Smithson C, Minton L. Value at Risk [J]. Risk, Jan. 1996,9(1): 25:27.
 Duffie D, Pan J. An overview of Value at Risk[J]. Journal of Derivatives, 1997,4(3):7.
 J.P. Morgan. RiskMetrics Technology Document[M]. 4th Edition: Internet: http://www.jpmorgan.com.
1996.
 Kevin Dowd. Beyond Value at Risk[M]. John Wiley & SONS. 1998 61-120
 Y. FAN. VaR Methodology and Its Application to Stock Market Risk Analysis in China [J]. Chinese
Journal of Management Science. 2000 8(3):26-32.

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