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DRAKE UNIVERSITY

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Market Risk

and Value at Risk

Finance 129

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Market Risk

Macroeconomic changes can create

uncertainty in the earnings of the Financial

institutions trading portfolio.

Important because of the increased emphasis

on income generated by the trading portfolio.

The trading portfolio (Very liquid i.e. equities,

bonds, derivatives, foreign exchange) is not

the same as the investment portfolio (illiquid

ie loans, deposits, long term capital).

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Importance of Market Risk

Measurement

Management information Provides info on the risk

exposure taken by traders

Setting Limits Allows management to limit

positions taken by traders

Resource Allocation Identifying the risk and return

characteristics of positions

Performance Evaluation trader compensation did

high return just mean high risk?

Regulation May be used in some cases to

determine capital requirements

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Measuring Market Risk

The impact of market risk is difficult to

measure since it combines many sources of

risk.

Intuitively all of the measures of risk can be

combined into one number representing the

aggregate risk

One way to measure this would be to use a

measure called the value at risk.

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Value at Risk

Value at Risk measures the market value

that may be lost given a change in the

market (for example, a change in interest

rates). that may occur with a corresponding

probability

We are going to apply this to look at market

risk.

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A Simple Example

Position A Position B

Payout Prob Payout Prob

-100 0.04 -100 0.04

0 0.96 0 0.96

VaR at 95%

confidence

level

0

VaR at 95%

confidence

level

0

From Dowd, Kevin 2002

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A second simple example

Assume you own a 10% coupon bond that

makes semi annual payments with 5 years until

maturity with a YTM of 9%.

The current value of the bond is then 1039.56

Assume that you believe that the most the yield

will increase in the next day is .2%. The new

value of the bond is 1031.50

The difference would represent the value at

risk.

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VAR

The value at risk therefore depends upon the

price volatility of the bond.

Where should the interest rate assumption

come from?

historical evidence on the possible change in

interest rates.

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Calculating VaR

Three main methods

Variance Covariance (parametric)

Historical

Monte Carlo Simulation

All measures rely on estimates of the

distribution of possible returns and the

correlation among different asset classes.

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Variance / Covariance Method

Assumes that returns are normally

distributed.

Using the characteristics of the normal

distribution it is possible to calculate the

chance of a loss and probable size of the loss.

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This slide and the next few based in part on Jorion, 1997

Probability

Cardano 1565 and Pascal 1654

Pascal was asked to explain how to divide up

the winnings in a game of chance that was

interrupted.

Developed the idea of a frequency distribution

of possible outcomes.

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An example

Assume that you are playing a game based

on the roll of two fair dice.

Each one has six possible sides that may land

face up, each face has a separate number, 1

to 6.

The total number of dice combinations is 36,

the probability that any combination of the

two dice occurs is 1/36

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Example continued

The total number shown on the dice ranges

from 2 to 12. Therefore there are a total of

12 possible numbers that may occur as part

of the 36 possible outcomes.

A frequency distribution summarizes the

frequency that any number occurs.

The probability that any number occurs is

based upon the frequency that a given

number may occur.

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Establishing the distribution

Let x be the random variable under

consideration, in this case the total number

shown on the two dice following each role.

The distribution establishes the frequency

each possible outcome occurs and therefore

the probability that it will occur.

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Discrete Distribution

Value 2 3 4 5 6 7 8 9 10 11 12

(x i)

Freq 1 2 3 4 5 6 5 4 3 2 1

(n i)

Prob 1 2 3 4 5 6 5 4 3 2 1

(p i) 36 36 36 36 36 36 36 36 36 36 36

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Cumulative Distribution

The cumulative distribution represents the

summation of the probabilities.

The number 2 occurs 1/36 of the time, the

number 3 occurs 2/36 of the time.

Therefore a number equal to 3 or less will

occur 3/36 of the time.

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Cumulative Distribution

Value 2 3 4 5 6 7 8 9 10 11 12

Prob 1 2 3 4 5 6 5 4 3 2 1

(p i) 36 36 36 36 36 36 36 36 36 36 36

Cdf 1 3 6 10 15 21 26 30 33 35 36

36 36 36 36 36 36 36 36 36 36 36

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Probability Distribution Function

(pdf)

The probabilities form a pdf. The sum of the

probabilities must sum to 1.

The distribution can be characterized by two

variables, its mean and standard deviation

1

11

1

=

= i

i

p

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Mean

The mean is simply the expected value from

rolling the dice, this is calculated by

multiplying the probabilities by the possible

outcomes (values).

In this case it is also the value with the

highest frequency (mode)

7

36

252

) (

11

1

= = =

= i

i i

x p x E

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Standard Deviation

The variance of the random variable is

defined as:

The standard deviation is defined as the

square root of the variance.

36

210

)] ( [ ) (

11

1

2

= =

= i

i i

x E x p x V

415 . 2 ) ( ) ( = = x V x SD

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Using the example in VaR

Assume that the return on your assets is

determined by the number which occurs

following the roll of the dice.

If a 7 occurs, assume that the return for that

day is equal to 0. If the number is less than 7

a loss of 10% occurs for each number less

than 7 (a 6 results in a 10% loss, a 5 results

in a 20% loss etc.)

Similarly if the number is above 7 a gain of

10% occurs.

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Discrete Distribution

Value 2 3 4 5 6 7 8 9 10 11 12

(x i)

Return -50% -40% -30% -20% -10% 0 10% 20% 30% 40% 50%

(n i)

Prob 1 2 3 4 5 6 5 4 3 2 1

(p i) 36 36 36 36 36 36 36 36 36 36 36

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VaR

Assume you want to estimate the possible

loss that you might incur with a given

probability.

Given the discrete dist, the most you might

lose is 50% of the value of your portfolio.

VaR combines this idea with a given

probability.

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VaR

Assume that you want to know the largest

loss that may occur in 95% of the rolls.

A 50% loss occurs 1/36 = 2.77% 0f the time.

This implies that 1-.027 =.9722 or 97.22% of

the rolls will not result in a loss of greater

than 40%.

A 40% or greater loss occurs in 3/36=8.33%

of rolls or 91.67% of the rolls will not result

in a loss greater than 30%

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Continuous time

The previous example assumed that there

were a set number of possible outcomes.

It is more likely to think of a continuous set of

possible payoffs.

In this case let the probability density function

be represented by the function f(x)

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Discrete vs. Continuous

Previously we had the sum of the probabilities

equal to 1. This is still the case, however the

summation is now represented as an integral

from negative infinity to positive infinity.

Discrete Continuous

1

11

1

=

= i

i

p

}

+

=1 ) ( dx x f

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Discrete vs. Continuous

The expected value of X is then found using

the same principle as before, the sum of the

products of X and the respective probabilities

Discrete Continuous

}

+

= dx x xf X E ) ( ) (

=

=

n

i

i i

x p X E

1

) (

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Discrete vs. Continuous

The variance of X is then found using the

same principle as before.

Discrete Continuous

}

+

= dx x f X E x X V ) ( )] ( [ ) (

2

=

=

N

i

i i

X E x p X V

1

2

)] ( [ ) (

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Combining Random Variables

One of the keys to measuring market risk is

the ability to combine the impact of changes

in different variables into one measure, the

value at risk.

First, lets look at a new random variable, that

is the transformation of the original random

variable X.

Let Y=a+bX where a and b are fixed

parameters.

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Linear Combination

The expected value of Y is then found using

the same principle as before, the sum of the

products of Y and the respective probabilities

}

+

= dx x xf X E ) ( ) (

}

+

= dx x yf Y E ) ( ) (

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Linear Combinations

We can substitute since Y=a+bX, then simplify by

rearranging

) (

) ( ) ( ) ( ) ( ) (

) ( ) (

X bE a

dx x xf b dx x f a dx x f bX a bX a E

dx x yf Y E

+ =

+ = + = +

=

} } }

}

+

+

+

+

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Variance

Similarly the variance can be found

}

}

}

+

+

+

= =

+ =

+ + = + =

) ( ) ( )] ( [

) ( )] ( [

) ( )] ( ) [( ) ( ) (

2 2 2

2

2

X V b dx x f X E x b

dx x f X bE a bx a

dx x f bX a E bX a bX a V Y V

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Standard Deviation

Given the variance it is easy to see that the standard

deviation will be

) (X bSD

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Combinations of Random

Variables

No let Y be the linear combination of two random

variables X

1

and X

2

the probability density function

(pdf) is now f(x

1

,x

2

)

The marginal distribution presents the distribution

as based upon one variable for example.

}

+

= ) ( ) , (

1 2 2 1 2

x f dx x x f

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Expectations

} }

} } } }

} } } }

} }

+

+

+

+

+

+

+

+

+

+

+

+

+ = + =

(

+

(

=

+ =

+ = +

) ( ) ( ) ( ) (

) , ( ) , (

) , ( ) , (

) , ( ) ( ) (

2 1 2 2 2 2 1 1 1 1

2 1 2 1 1 1 2 2 2 1 2 1 2 1 1

2 1 2 1 2 2 1 2 1 2 1 1 2 1

2 1 2 1 2 1 2 1 2 1

X E X E dx x f x dx x f x

dx dx x x f x x dx dx x x f x

dx dx x x f x dx dx x x f x

dx dx x x f x x X X E

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Variance

Similarly the variance can be reduced

) , ( 2 ) ( ) (

) , ( )] ( [

) (

2 1 2 1

2 1 2 1

2

2 1 2 1 2 1

2 1

X X Cov X V X V

dx dx x x f X X E x x

X X V

+ + =

+ + =

+

} }

+

+

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A special case

If the two random variables are independent

then the covariance will reduce to zero which

implies that

V(X

1

+X

2

) = V(X

1

)+V(X

2

)

However this is only the case if the variables

are independent implying hat there is no

gain from diversification of holding the two

variables.

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The Normal Distribution

For many populations of observations as the

number of independent draws increases, the

population will converge to a smooth normal

distribution.

The normal distribution can be characterized by its

mean (the location) and variance (spread) N(,o

2

).

The distribution function is

(

=

2

2

) (

2

1

2

2

1

) (

o

to

x

e x f

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Standard Normal Distribution

The function can be calculated for various

values of mean and variance, however the

process is simplified by looking at a standard

normal distribution with mean of 0 and

variance of 1.

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Standard Normal Distribution

Standard Normal Distributions are symmetric

around the mean. The values of the

distribution are based off of the number of

standard deviations from the mean.

One standard deviation from the mean

produces a confidence interval of roughly

68.26% of the observations.

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Prob Ranges for Normal Dist.

68.26%

95.46%

99.74%

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An Example

Lets define X as a function of a standard normal

variable c (in other words c is N(0,1))

X= + co

We showed earlier that

Therefore

) ( ) ( X bE a bX a E + = +

c o oc = + = + ) ( ) ( E E

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Variance

We showed that the variance was equal to

Therefore

2 2

) ( ) ( o c o oc = = + V V

) ( ) (

2

X V b bX a V = +

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An Example

Assume that we know that the movements in

an exchange rate are normally distributed

with mean of 1% and volatility of 12%.

Given that approximately 95% of the

distribution is within 2 standard deviations of

the mean it is easy to approximate the

highest and lowest return with 95%

confidence

X

MIN

= 1% - 2(12%) = -23%

X

MAX

= 1% + 2(12%) = +25%

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One sided values

Similarly you can find the standard deviation

that represents a one sided distribution.

Given that 95.46% of the distribution lies

between -2 and +2 standard deviations of the

mean, it implies that (100% - 95.46)/2 =

2.27% of the distribution is in each tail.

This shows that 95.46% + 2.27% = 97.73%

of the distribution is to the right of this point.

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VaR

Given the last slide it is easy to see that you

would be 97.73% confident that the loss

would not exceed -23%.

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Continuous Time

Let q represent quantile such that the area to

the right of q represents a given probability of

occurrence.

In our example above -2.00 would produce a

probability of 97.73% for the standard normal

distribution

}

+

= > =

q

dx x f q X prob c ) ( ) (

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VAR A second example

Assume that the mean yield change on a bond

was zero basis points and that the standard

deviation of the change was 10 Bp or 0.001

Given that 90% of the area under the normal

distribution is within 1.65 standard deviations

on either side of the mean (in other words

between mean-1.65o and mean +1.65o)

There is only a 5% chance that the level of

interest rates would increase or decrease by

more than 0 + 1.65(0.001) or 16.5 Bp

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Price change associated with

16.5Bp change.

You could directly calculate the price change,

by changing the yield to maturity by 16.5 Bp.

Given the duration of the bond you also could

calculate an estimate based upon duration.

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Example 2

Assume we own seven year zero coupon

bonds with a face value of $1,631,483.00

with a yield of 7.243%

Todays Market Value

$1,631,483/(1.07243)

7

=$1,000,000

If rates increase to 7.408 the market value is

$1,631,483/(1.07408)

7

= $989,295.75

Which is a value decrease of $10,704.25

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Approximations - Duration

The duration of the bond would be 7 since it

is a zero coupon.

Modified duration is then 7/1.07143 = 6.527

The price change would then be

1,000,000(-6.57)(.00165) = $10,769.55

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Approximations - linear

Sometimes it is also estimated by figuring the

the change in price per basis point.

If rates increase by one basis point to 7.253%

the value of the bond is $999,347.23 or a

price decrease of $652.77.

This is a 652.77/1,000,000 = .06528%

change in the price of the bond per basis

point

The value at risk is then

1,000,000(.00065277)(16.5) = $10,770.71

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Precision

The actual calculation of the change should

be accomplished by discounting the value of

the bond across the zero coupon yield curve.

In our example we only had one cash flow.

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DEAR

Since we assumed that the yield change was

associated with a daily movement in rates, we

have calculated a daily measure of risk for the

bond.

DEAR = Daily Earnings at Risk

DEAR is often estimated using our linear

measure:

(market value)(price sensitivity)(change in yield)

Or

(Market value)(Price Volatility)

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VAR

Given the DEAR you can calculate the Value

at Risk for a given time frame.

VAR = DEAR(N)

0.5

Where N = number of days

(Assumes constant daily variance and no

autocorrelation in shocks)

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N

Bank for International Settlements (BIS) 1998

market risk capital requirements are based on

a 10 day holding period.

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Problems with estimation

Fat Tails Many securities have returns that

are not normally distributed, they have fat

tails This will cause an underestimation of

the risk when a normal distribution is used.

Do recent market events change the

distribution? Risk Metrics weights recent

observations higher when calculating

standard Dev.

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Interest Rate Risk vs.

Market Risk

Market risk is more broad, but Interest Rate

Risk is a component of Market Risk.

Market risk should include the interaction of

other economic variables such as exchange

rates.

Therefore, we need to think about the

possibility of an adverse event in the

exchange rate market and equity markets

etc.. Not just a change in interest rates..

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DEAR of a foreign Exchange Position

Assume the firm has Swf 1.6 Million trading

position in swiss francs

Assume that the current exchange rate is

Swf1.60 / $1 or $.0625 / Swf

The $ value of the francs is then

Swf1.6 million ($0.0625/Swf) =$1,000,000

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FX DEAR

Given a standard deviation in the exchange

rate of 56.5Bp and the assumption of a

normal distribution it is easy to find the DEAR.

We want to look at an adverse outcome that

will not occur more than 5% of the time so

again we can look at 1.65o

FX volatility is then 1.65(56.5bp) = 93.2bp or

0.932%

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FX DEAR

DEAR = (Dollar value )( FX volatility)

=($1,000,000)(.00932)

=$9,320

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Equity DEAR

The return on equities can be split into

systematic and unsystematic risk.

We know that the unsystematic risk can be

diversified away.

The undiversifiable market risk will equal be

based on the beta of the individual stock

2 2

m i

o |

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Equity DEAR

If the portfolio of assets has a beta of 1 then

the market risk of the portfolio will also have

a beta of 1 and the standard deviation of the

portfolio can be estimated by the standard

deviation of the market.

Let o

m

= 2% then using the same confidence

interval, the volatility of the market will be

1.65(2%) = 3.3%

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Equity DEAR

DEAR = (Dollar value )( Equity volatility)

=($1,000,000)(0.033)

=$33,000

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VAR and Market Risk

The market risk should then estimate the

possible change from all three of the asset

classes.

This DOES NOT just equal the summation of

the three estimates of DEAR because the

covariance of the returns on the different

assets must be accounted for.

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Aggregation

The aggregation of the DEAR for the three

assets can be thought of as the aggregation

of three standard deviations.

To aggregate we need to consider the

covariance among the different asset classes.

Consider the Bond, FX position and Equity

that we have recently calculated.

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Variance Covariance

Seven Year

zero

Swf/$1

US Stock

Index

Seven Year

Zero

1 -.20 .4

Swf/$1 1 .1

US Stock

Index

1

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variance covariance

2

1

US z,

US Swf,

Swf z,

2

US

2

Swf

2

Z

) 2 (

) 2 (

) 2 (

) (DEAR ) (DEAR ) (DEAR

Portfolio

DEAR

(

(

(

(

(

+

+

+

+ +

=

US Z

US Swf

Swf Z

DEAR DEAR

DEAR DEAR

DEAR DEAR

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VAR for Portfolio

969 , 39 $

) 33 )( 77 . 10 )( 4 )(. 2 (

) 33 )( 32 . 9 )( 1 )(. 2 (

) 32 . 9 )( 77 . 10 )( 2 . ( 2 (

) (33 ) (9.32 ) (10.77

Portfolio

DEAR

2

1

2 2 2

=

(

(

(

(

(

+

+

+

+ +

=

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Comparison

If the simple aggregation of the three

positions occurred then the DEAR would have

been estimated to be $53,090. It is easy to

show that the if all three assets were perfectly

correlated (so that each of their correlation

coefficients was 1 with the other assets) you

would calculate a loss of $52,090.

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Risk Metrics

JP Morgan has the premier service for

calculating the value at risk

They currently cover the daily updating and

production of over 450 volatility and

correlation estimates that can be used in

calculating VAR.

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Normal Distribution Assumption

Risk Metrics is based on the assumption that

all asset returns are normally distributed.

This is not a valid assumption for many assts

for example call options the most an

investor can loose is the price of the call

option. The upside is large, this implies a

large positive skew.

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Normal Assumption Illustration

Assume that a financial institution has a large

number of individual loans. Each loan can be

thought of as a binomial distribution, the loan

either repays in full or there is default.

The sum of a large number of binomial

distributions converges to a normal

distribution assuming that the binomial are

independent.

Therefore the portfolio of loans could b

thought of as a normal distribution.

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Normal Illustration continued

However, it is unlikely that the loans are truly

independent. In a recession it is more likely

that many defaults will occur.

This invalidates the normal distribution

assumption.

The alternative to the assumption is to use a

historical back simulation.

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Historical Simulation

Similar to the variance covariance approach,

the idea is to look at the past history over a

given time frame.

However, this approach looks at the actual

distribution that were realized instead of

attempting to estimate it as a normal

distribution.

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Back Simulation

Step 1: Measure exposures. Calculate the

total $ valued exposure to each assets

Step 2: Measure sensitivity. Measure the

sensitivity of each asset to a 1% change in

each of the other assets. This number is the

delta.

Step 3: Measure Risk. Look at the annual %

change of each asset for the past day and

figure out the change in aggregate exposure

that day.

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Back Simulation

Step 4 Repeat step 3 using historical data for

each of the assets for the last 500 days

Step 5 Rank the days from worst to best.

Then decide on a confidence level. If you

want a 5% probability look at the return with

95% of the returns better and 5% of the

return worse.

Step 6 calculate the VAR

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Historical Simulation

Provides a worst case scenario, where Risk

metrics the worst case is a loss of negative

infinity

Problems:

The 500 observations is a limited amount, thus

there is a low degree of confidence that it

actually represents a 5% probability. Should

we change the number of days??

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Monte Carlo Approach

Calculate the historical variance covariance

matrix.

Use the matrix with random draws to simulate

10,000 possible scenarios for each asset.

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BIS Standardized Framework

Bank of International Settlements proposed a

structured framework to measure the market

risk of its member banks and the offsetting

capital required to manage the risk.

Two options

Standardized Framework (reviewed below)

Firm Specific Internal Framework

Must be approved by BIS

Subject to audits

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Risk Charges

Each asset is given a specific risk charge

which represents the risk of the asset

For example US treasury bills have a risk

weight of 0 while junk and would have a risk

weight of 8%.

Multiplying the value of the outstanding

position by the risk charges provides capital

risk charge for each asset.

Summing provides a total risk charge

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Specific Risk Charges

Specific Risk charges are intended to measure

the risk of a decline in liquidity or credit risk

of the trading portfolio.

Using these produces a specific capital

requirement for each asset.

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General Market Risk Charges

Reflect the product of the modified duration

and expected interest rate shocks for each

maturity

Remember this is across different types of

assets with the same maturity.

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Vertical Offsets

Since each position has both long and short

positions for different assets, it is assumed

that they do not perfectly offset each other.

In other words a 10 year T-Bond and a high

yield bond with a 10 year maturity.

To counter act this the is a vertical offset or

disallowance factor.

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Horizontal Offsets

Within Zones

For each maturity bucket there are

differences in maturity creating again the

inability to let short and long positions exactly

offset each other.

Between Zones

Also across zones the short an long positions

must be offset.

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VaR Problems

Artzner (1997), (1999) has shown that VaR is

not a coherent measure of risk.

For Example it does not posses the property

of subadditvity. In other words the combined

portfolio VaR of two positions can be greater

than the sum of the individual VaRs

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A Simple Example*

Assume a financial institution is facing the

following three possible scenarios and

associated losses

Scenario Probability Loss

1 .97 0

2 .015 100

3 .015 0

The VaR at the 98% level would equal = 0

*This and subsequent examples are based on Meyers

2002

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A Simple Example

Assume you the previous financial institution and its

competitor facing the same three possible scenarios

Scenario Probability Loss A Loss B Loss A & B

1 .97 0 0 0

2 .015 100 0 100

3 .015 0 100 100

The VaR at the 98% level for A or B alone is 0

The Sum of the individual VaRs = VaR

A

+ VaR

B

= 0

The VaR at the 98% level for A and B combined

VaR

(A+B)

=100

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Coherence of risk measures

Let (X) and (Y) be measures of risk

associated with event X and event Y

respectively

Subadditvity implies (X+Y) < (X) + (Y).

Monotonicity. Implies X>Y then (X) > (Y).

Positive homogeneity:Given > 0 (X) =

(X).

Translation Invariance. Given an additional

constant amount of loss o, (X+o) = (X)+o.

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Coherent Measures of Risk

Artzner (1997, 1999) Acerbi and Tasche

(2001a,2001b), Yamai and Yoshiba (2001a,

2001b) have pointed to Conditional Value at Risk

or Tail Value at Risk as coherent measures.

CVaR and TVaR measure the expected loss

conditioned upon the loss being above the VaR

level.

Lien and Tse (2000, 2001) Lien and Root (2003)

have adopted a more general method looking at

the expected shortfall

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Tail VaR*

TVaR

o

(X) = Average of the top (1-o)% loss

For comparison let VaR

o

(X) = the (1-o)% loss

* Meyers 2002 The Actuarial Review

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Scenario X

1

X

2

X

1

+X

2

1 4 5 9

2 2 1 3

3 1 2 3

4 5 4 9

5 3 3 6

VaR

60%

4 4 9

TVaR

60%

4.5 4.5 9

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Normal Distribution

How important is the assumption that

everything is normally distributed?

It depends on how and why a distribution

differs from the normal distribution.

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S&P 500 Monthly Returns vs. Normal Dist

-30

20

70

120

170

220

- 0 . 4 7 5 - 0 . 4 2 5 - 0 . 3 7 5 - 0 . 3 2 5 - 0 . 2 7 5 - 0 . 2 2 5 - 0 . 1 7 5 - 0 . 1 2 5 - 0 . 0 7 5 - 0 . 0 2 5 0 . 0 2 5 0 . 0 7 5 0 . 1 2 5 0 . 1 7 5 0 . 2 2 5 0 . 2 7 5 0 . 3 2 5 0 . 3 7 5 0 . 4 2 5 0 . 4 7 5

Returns

O

b

s

e

r

v

a

t

i

o

n

s

S&P

Nor mal

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Bond returns vs. Normal

0

50

100

150

200

250

-0.09 -0.07 -0.05 -0.03 -0.01 0.01 0.03 0.05 0.07 0.09

Returns

O

b

s

e

r

v

a

t

i

o

n

s

LT Corp

LT Govt

Norm

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Two explanations of Fat Tails

The true distribution is stationary and

contains fat tails.

In this case normal distribution would be

inappropriate

The distribution does change through time.

Large or small observations are outliers drawn

from a distribution that is temporarily out of

alignment.

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Implications

Both explanations have some truth, it is

important to estimate variations from the

underlying assumed distribution.

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Measuring Volatilities

Given that the normality assumption is central

to the measurement of the volatility and

covariance estimates, it is possible to attempt

to adjust for differences from normality.

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Moving Average

One solution is to calculate the moving average of

the volatility

M

r

M

i

i t

=

=

1

2

o

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Drake University

Moving Averages

Moving Avergages of Volatility S&P 500 Monthly Return

0

0.002

0.004

0.006

0.008

0.01

0.012

0.014

0.016

0.018

0 100 200 300 400 500 600 700 800 900

1 year

2 year

5 year

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Historical Simulation

Another approach is to take the daily price

returns and sort them in order of highest to

lowest.

The volatility is then found based off of a

confidence interval.

Ignores the normality assumption! But

causes issues surrounding window of

observations.

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Nonconstant Volatilities

So far we have assumed that volatility is

constant over time however this may not be

the case.

It is often the case that clustering of returns

is observed (successive increases or

decreases in returns), this implies that the

returns are not independent of each other as

would be required if they were normally

distributed.

If this is the case, each observation should

not be equally weighted.

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RiskMetrics

JP Morgan uses an Exponentially Weighted

Moving Average.

This method used a decay factor that

weights each days percentage price change.

A simple version of this would be to weight by

the period in which the observation took

place.

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Risk Metrics

Where

is the decay factor

n is the number of days used to derive the

volatility

Is the mean value of the distribution (assumed to

be zero for most VaR estimates)

=

=

=

1

2

) ( ) 1 (

t

n t

t

t

X o

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Drake University

Decay Factors

JP Morgan uses a decay factor of .94 for daily

volatility estimates and .97 for monthly

volatility estimates

The choice of .94 for daily observations

emphasizes that they are focused on very

recent observations.

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Decay Factors

0

0.01

0.02

0.03

0.04

0.05

0.06

0 20 40 60 80 100 120 140 160

Days

W

e

i

g

h

t

i

n

g

0.94

0.97

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Measuring Correlation

Covariance:

Combines the relationship between the stocks

with the volatility.

(+) the stocks move together

(-) The stocks move opposite of each other

=

i B Bi A Ai

P k k k k AB Cov ) )( ( ) (

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Measuring Correlation 2

Correlation coefficient: The covariance is

difficult to compare when looking at different

series. Therefore the correlation coefficient is

used.

The correlation coefficient will range from

-1 to +1

) /( ) (

B A AB

AB Cov r o o =

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Timing Errors

To get a meaningful correlation the price

changes of the two assets should be taken at

the exact same time.

This becomes more difficult with a higher

number of assets that are tracked.

With two assets it is fairly easy to look at a

scatter plot of the assets returns to see if the

correlations look normal

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Size of portfolio

Many institutions do not consider it practical

to calculate the correlation between each pair

of assets.

Consider attempting to look at a portfolio that

consisted of 15 different currencies. For each

currency there are asset exposures in various

maturities.

To be complete assume that the yield curve

for each currency is broken down into 12

maturities.

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Correlations continued

The combination of 12 maturities and 15

currencies would produce 15 x 12 = 180

separate movements of interest rates that

should be investigated.

Since for each one the correlation with each

of the others should be considered, this would

imply 180 x 180 = 16,110 separate

correlations that would need to be

maintained.

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Reducing the work

One possible solution to this would be

reducing the number of necessary

correlations by looking at the mid point of

each yield curve.

This works IF

There is not extensive cross asset trading

(hedging with similar assets for example)

There is limited spread trading (long in one

assert and short in another to take advantage

of changes in the spread)

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A compromise

Most VaR can be accomplished by developing

a hierarchy of correlations based on the

amount of each type of trading. It also will

depend upon the aggregation in the portfolio

under consideration. As the aggregation

increases, fewer correlations are necessary.

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Back Testing

To look at the performance of a VaR model,

can be investigated by back testing.

Back testing is simply looking at the loss on a

portfolio compared to the previous days VaR

estimate.

Over time the number of days that the VaR

was exceed by the loss should be roughly

similar to the amount specified by the

confidence in the model

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Basle Accords

To use VaR to measure risk the Basle accords

specify that banks wishing to use VaR must

undertake two different types of back testing.

Hypothetical freeze the portfolio and test

the performance of the VaR model over a

period of time

Trading Outcome Allow the portfolio to

change (as it does in actual trading) and

compare the performance to the previous

days VaR.

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Back Testing Continued

Assume that we look at a 1000 day window

of previous results. A 95% confidence

interval implies that the VaR level should have

been exceed 50 times.

Should the model be rejected if the it is found

that the VaR level was exceeded 55 times?

70 times? 100 times?

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Back test results

Whether or not the actual number of

exceptions differs significantly from the

expectation can be tested using the Z score

for a binomial distribution.

Type I error the model has been

erroneously rejected

Type II error the model has been

erroneously accepted.

Basle specifies a type one error test.

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One tail versus two tail

Basle does not care if the VaR model

overestimates the amount of loss and the

number of exceptions is low ( implies a one

tail test)

The bank, however, does care if the number

of exceptions is low and it is keeping too

much capital (implies a two tail test).

Excess Capital

Trading performance based upon economic

capital

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Approximations

Given a two tail 95% confidence test and 1000

days of back testing the bank would accept 39

to 61 days that the loss exceeded the VaR

level.

However this implies a 90% confidence for the

one tail test so Basle would not be satisfied.

Given a two tail test and a 99% confidence

level the bank would accept 6 to 14 days that

the loss exceeded the trading level, under the

same test Basle would accept 0 to 14 days.

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Empirical Analysis of VaR

(Best 1998)

Whether or not the lack of normality is not a

problem was discussed by Best 1998

(Implementing VaR)

Five years of daily price movements for 15

assets from Jan 1992 to Dec 1996. The

sample process deliberately chose assets that

may be non normal.

VaR Was calculated for each asset individually

and for the entire group as a portfolio.

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Figures 4. Empirical Analysis of VaR

(Best 1998)

All Assets have fatter tails than expected

under a normal distribution.

Japanese 3-5 year bonds show significant

negative skew

The 1 year LIBOR sterling rate shows nothing

close to normal behavior

Basic model work about as well as more

advanced mathematical models

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Basle Tests

Requires that the VaR model must calculate

VaR with a 99% confidence and be tested

over at least 250 days.

Table 4.6

Low observation periods perform poorly while

high observation periods do much better.

Clusters of returns cause problem for the

ability of short term models to perform, this

assumes that the data has a longer memory

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Basle

The Basle requirements supplement VaR by

Requiring that the bank originally hold 3 times

the amount specified by the VaR model.

This is the product of a desire to produce

safety and soundness in the industry

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Stress Testing

Value at Risk should be supplemented with

stress testing which looks at the worst

possible outcomes.

This is a natural extension of the historical

simulation approach to calculating variance.

VaR ignores the size of the possible loss, if

the VaR limit is exceeded, stress testing

attempts to account for this.

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Stress Testing

Stress Testing is basically a large scenario

analysis. The difficulty is identifying the

appropriate scenarios.

The key is to identify variables that would

provide a significant loss in excess of the VaR

level and investigate the probability of those

events occurring.

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Stress Tests

Some events are difficult to predict, for

example, terrorism, natural disasters, political

changes in foreign economies.

In these cases it is best to look at similar past

events and see the impact on various assets.

Stress testing does allow for estimates of

losses above the VaR level.

You can also look for the impact of clusters of

returns using stress testing.

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Stress Testing with

Historical Simulation

The most straightforward approach is to look

at changes in returns.

For example what is the largest loss that

occurred for an asset over the past 100 days

(or 250 days or)

This can be combined with similar outcomes

for other assets to produce a worst case

scenario result.

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Stress Testing

Other Simulation Techniques

Monte Carlo simulation can also be employed

to look at the possible bad outcomes based

on past volatility and correlation.

The key is that changes in price and return

that are greater than those implied by a three

standard deviation change need to be

investigated.

Using simulation it is also possible to ask what

happens it correlations change, or volatility

changes of a given asset or assets.

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Managing Risk with VaR

The Institution must first determine its

tolerance for risk.

This can be expressed as a monetary amount

or as a percentage of an assets value.

Ultimately VaR expresses an monetary

amount of loss that the institution is willing to

suffer and a given frequency determined by

the timing confidence level..

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Managing Risk with VaR

The tolerance for loss most likely increases

with the time frame. The institution may be

willing to suffer a greater loss one time each

year (or each 2 years or 5 years), but that is

different than one day VaR.

For Example, given a 95% confidence level

and 100 trading days, the one day VaR would

occur approximately once a month.

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Setting Limits

The VaR and tolerance for risk can be used to

set limits that keep the institution in an

acceptable risk position.

Limits need to balance the ability of the

traders to conduct business and the risk

tolerance of the institution. Some risk needs

to be accepted for the return to be earned.

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VaR Limits

Setting limits at the trading unit level

Allows trading management to balance the

limit across traders and trading activities.

Requires management to be experts in the

calculation of VaR and its relationship with

trading practices.

Limits for individual traders

VaR is not familiar to most traders (they d o

not work with it daily and may not understand

how different choices impact VaR.

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VaR and changes in volatility

One objection of many traders is that a

change in the volatility (especially if it is

calculated based on moving averages) can

cause a change in VaR on a given position.

Therefore they can be penalized for a position

even if they have not made any trading

decisions.

Is the objection a valid reason to not use

VaR?

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Stress Test Limits

Similar to VaR limits should be set on the

acceptable loss according to stress limit

testing (and its associated probability).

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