Hull RMFICh 10

Market Risk VaR:
Model-Building
Approach
Chapter 10
Risk Management and Financial Institutions, Chapter 10, Copyright John C. Hull 2006
10.1
The Model-Building Approach
The main alternative to historical simulation is to

make assumptions about the probability
distributions of the returns on the market
variables and calculate the probability
distribution of the change in the value of the
portfolio analytically
This is known as the model building approach or
the variance-covariance approach
10.2
Daily Volatilities (page 234)
In option pricing we express volatility as

volatility per year
In VaR calculations we express volatility
as volatility per day
day
y ear
252
10.3
Daily Volatility continued
Strictly speaking we should define day as

the standard deviation of the continuously
compounded return in one day
In practice we assume that it is the
standard deviation of the percentage
change in one day
10.4
Microsoft Example (page 234-5)
We have a position worth $10 million in

Microsoft shares
The volatility of Microsoft is 2% per day
(about 32% per year)
We use N=10 and X=99
10.5
Microsoft Example continued
The standard deviation of the change in

the portfolio in 1 day is $200,000
The standard deviation of the change in 10
days is
200,000 10 $632,456
10.6
Microsoft Example continued
We assume that the expected change in

the value of the portfolio is zero (This is
OK for short time periods)
We assume that the change in the value of
the portfolio is normally distributed
Since N(2.33)=0.01, the VaR is
2.33 632,456 $1,473,621

10.7
AT&T Example
Consider a position of $5 million in AT&T

The daily volatility of AT&T is 1% (approx
16% per year)
The SD per 10 days is
50,000 10 $158,144
The VaR is
158,114 2.33 $368,405

10.8
Portfolio (page 235)
Now consider a portfolio consisting of both

Microsoft and AT&T
Suppose that the correlation between the
returns is 0.3
10.9
S.D. of Portfolio
A standard result in statistics states that

X Y 2r X Y
2
X
2
Y
In this case X = 200,000 and Y = 50,000

and r = 0.3. The standard deviation of the
change in the portfolio value in one day is
therefore 220,227
10.10
VaR for Portfolio
The 10-day 99% VaR for the portfolio is

220,227 10 2.33 $1,622,657
The benefits of diversification are

(1,473,621+368,405)1,622,657=$219,369
What is the incremental effect of the AT&T
holding on VaR?
10.11
The Linear Model

We assume
The daily change in the value of a portfolio
is linearly related to the daily returns from
market variables
The returns from the market variables are
normally distributed
10.12
The General Linear Model

continued (equations 10.1 and 10.2, page 237)
n
P i xi
i 1
n
n
2P i j i j rij
i 1 j 1
n
2
i
i 1
2P i2 2 i j i j rij
i j
where i is the volatilit y of variable i

and P is the portfolio' s standard deviation
10.13
Alternatives for Handling Interest

Rates
Duration approach: Linear relation

between P and y but assumes parallel
shifts)
Cash flow mapping: Variables are zerocoupon bond prices with about 10 different
maturities
Principal components analysis: 2 or 3
independent shifts with their own
volatilities
10.14
Handling Interest Rates: Cash

Flow Mapping (page 239)
We choose as market variables zero-coupon

bond prices with standard maturities (1mm,
3mm, 6mm, 1yr, 2yr, 5yr, 7yr, 10yr, 30yr)
Suppose that the 5yr rate is 6% and the 7yr rate
is 7% and we will receive a cash flow of $10,000
in 6.5 years.
The volatilities per day of the 5yr and 7yr bonds
are 0.50% and 0.58% respectively
10.15
Example continued
We interpolate between the 5yr rate of 6%

and the 7yr rate of 7% to get a 6.5yr rate
of 6.75%
The PV of the $10,000 cash flow is
10 ,000
6,540
6 .5
1.0675
10.16
Example continued
We interpolate between the 0.5% volatility

for the 5yr bond price and the 0.58%
volatility for the 7yr bond price to get
0.56% as the volatility for the 6.5yr bond
We allocate of the PV to the 5yr bond
and (1- ) of the PV to the 7yr bond
10.17
Example continued
Suppose that the correlation between

movement in the 5yr and 7yr bond prices
is 0.6
To match variances
0.56 2 0.52 2 0.582 (1 ) 2 2 0.6 0.5 0.58 (1 )
This gives =0.074
10.18
Example continued
The value of 6,540 received in 6.5 years
6,540 0.074 $484
in 5 years and by
6,540 0.926 $6,056
in 7 years.
This cash flow mapping preserves value
and variance
10.19
Principal Components Analysis

(page 241)
Suppose we calculate
P 0.08 f1 4.40 f 2
where f1 is the first factor and f2 is the

second factor
If the SD of the factor scores are 17.49
and 6.05 the SD of P is
0.082 17.492 4.402 6.052 26.66
10.20
When Linear Model Can be Used
Portfolio of stocks
Portfolio of bonds
Forward contract on foreign currency
Interest-rate swap
10.21
The Linear Model and Options

Consider a portfolio of options dependent
on a single stock price, S. Define
P
and
S
x
S
10.22
Linear Model and Options

continued
As an approximation
Similarly when there are many underlying

market variables
P S S x
P Si i xi
i
where i is the delta of the portfolio with

respect to the ith asset
10.23
Example
Consider an investment in options on Microsoft

and AT&T. Suppose the stock prices are 120
and 30 respectively and the deltas of the
portfolio with respect to the two stock prices are
1,000 and 20,000 respectively
As an approximation
P 120 1,000x1 30 20,000x2
where x1 and x2 are the percentage changes

in the two stock prices
10.24
Skewness
(See Figures 10.1, 10.2, and 10.3)
The linear model fails to capture skewness

in the probability distribution of the
portfolio value.
10.25
Quadratic Model
(page 246-7)
For a portfolio dependent on a single stock price it is
approximately true that
P S
so that
P S x
1
(S ) 2
2
1 2
S (x) 2
2
Moments are
E (P ) 0.5S 2 2
E (P 2 ) S 2 2 2 0.75 S 4 2 4
E (P 3 ) 4.5S 4 2 4 1.875 S 6 3 6
10.26
Quadratic Model continued

With many market variables and each instrument
dependent on only one
n
1 2
P Si i xi Si i (xi ) 2
i 1
i 1 2
where i and i are the delta and gamma of the portfolio

with respect to the ith variable
Formulas for calculating moments exist but are fairly
complicated
What happens when each instrument can be dependent
on several market variables?
10.27
Cornish Fisher Expansion (page 247)

Cornish Fisher expansion can be used to
calculate fractiles of the distribution of P
from the moments of the distribution
10.28
Monte Carlo Simulation (page 248)

To calculate VaR using MC simulation we
Value portfolio today
Sample once from the multivariate
distributions of the xi
Use the xi to determine market variables
at end of one day
Revalue the portfolio at the end of day
10.29
Monte Carlo Simulation continued
Calculate P
Repeat many times to build up a
probability distribution for P
VaR is the appropriate fractile of the
distribution times square root of N
For example, with 1,000 trial the 1
percentile is the 10th worst case.
10.30
Speeding up Calculations with the

Partial Simulation Approach
Use the approximate delta/gamma

relationship between P and the xi to
calculate the change in value of the
portfolio
This can also be used to speed up the
historical simulation approach
10.31
Alternative to Normal Distribution

Assumption in Monte Carlo
In a Monte Carlo simulation we can

assume non-normal distributions for the xi
(e.g., a multivariate t-distribution)
Can also use a Gaussian or other copula
model
10.32
Model Building vs Historical

Simulation
Model building approach is used for
investment portfolios, but it does not
usually work well for portfolios involving
options that are close to delta neutral
10.33

Hull RMFICh 10

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Market Risk VaR:

The Model-Building Approach

The main alternative to historical simulation is to

Daily Volatilities (page 234)

In option pricing we express volatility as

Daily Volatility continued

Strictly speaking we should define day as

Microsoft Example (page 234-5)

We have a position worth $10 million in

Microsoft Example continued

The standard deviation of the change in

Microsoft Example continued

We assume that the expected change in

2.33 632,456 $1,473,621

Consider a position of $5 million in AT&T

158,114 2.33 $368,405

Portfolio (page 235)

Now consider a portfolio consisting of both

A standard result in statistics states that

In this case X = 200,000 and Y = 50,000

VaR for Portfolio

The 10-day 99% VaR for the portfolio is

The benefits of diversification are

The Linear Model

The General Linear Model

where i is the volatilit y of variable i

Alternatives for Handling Interest

Duration approach: Linear relation

Handling Interest Rates: Cash

We choose as market variables zero-coupon

We interpolate between the 5yr rate of 6%

We interpolate between the 0.5% volatility

Suppose that the correlation between

This gives =0.074

Principal Components Analysis

where f1 is the first factor and f2 is the

When Linear Model Can be Used

The Linear Model and Options

Linear Model and Options

Similarly when there are many underlying

where i is the delta of the portfolio with

Consider an investment in options on Microsoft

where x1 and x2 are the percentage changes

The linear model fails to capture skewness

Quadratic Model continued

where i and i are the delta and gamma of the portfolio

Cornish Fisher Expansion (page 247)

Monte Carlo Simulation (page 248)

Monte Carlo Simulation continued

Speeding up Calculations with the

Use the approximate delta/gamma

Alternative to Normal Distribution

In a Monte Carlo simulation we can

Model Building vs Historical

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