Risk Management and

Derivatives
Lecture 03
Value-at-Risk 1

Unit Content
Week 1: Introduction to Risk, Risk Management and Derivatives
Week 2: Financial Statistics
Week 3: Value-at-Risk 1
Week 4: No Classes Ekka Public Holiday
Week 5: Value-at-Risk 2
Week 6: Forwards and Futures: commodity and equity
Week 7: Forwards and Futures: interest rates
Week 8: Mid-Semester Exam and Reflective Practices
Week 9: Swaps: interest rate
Week 10: Options: introduction and pricing with the binomial
model
Week 11: Options: pricing with the Black-Scholes model
Week 12: Options: trading strategies and risk management
Week 13: Derivative Disasters
2
Week 14: Revision

Lecture Outline
Normal Distribution
Value-at-Risk (VaR)

Defined
Empirical/Historical Simulation VaR
Normal VaR
Constant and Time Varying Volatility
Applications
Criticisms

Readings:
RiskMetrics (1996) Technical Document, pp. 5-9, 45-56, 64-72, 77-88
and 93-101. Skim pp.21-30. Note: use the lecture notes as a guide to
what to focus on.
Hull et al. (2013) Fundamentals of Futures and Options, Ch. 20, pp.
419-431 and 436-442. Mathematical Appendix, pp. 531-538.
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Normal Distribution
The normal distribution is a probability distribution where

The area under the curve is 1 (A + B + C + D =1).

It is symmetric around the mean (skewness = 0), which
implies

mean = median = mode

50% of probability mass is below the mean and 50% is above the mean
(A+C = B+D = 0.5).
probability mass from moving x-STDS to the left or right of the mean is
the same (A=B).

2x
It is fully2 xcharacterised
by two parameters, the mean () and
variance ().
Normal Probability Density Function (pd

measures height of distribution

C

Normal Distribution
Standard Normal Distribution

Is normal distribution where

and
2x

C=
0.025

To get the probabilities, you need to

measure the area under the curve
Normal Cumulative Density Function (cd
measures area under the curve

2x

A
B
= 0.475
= 0.475

D=
0.025

=0

This integral is calculated numerically

with normal tables or in excel (=normsdist

Normal Distribution

Normal Distribution
Location (mean)

Starting from the standard normal, you can shift the

mean by simply adding to , such that
Note that = 1

Normal Distribution
Spread (standard deviation)

Starting from the standard normal, you can spread the

distribution by simply multiplying by , such that
Note that

Normal Distribution
Mean and Spread

Starting from the standard normal, you can move the mean
and spread the distribution by multiplying by and adding ,
such that .

Normal Distribution
Therefore, to change the standard normal random
variable,

, to any other normal random variable, , simply

adjust to get

Rearranged for

This is why the pdf is

And why we talk about normally distributed variables as

being standard deviations from their mean.

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Normal Distribution
Empirical Rule:
68% of observations lie 1 STD either side of the mean.
95% of observations lie 2 STDs either side of the mean.
99% of observations lie 3 STDs either side of the mean.
3

2
1

-3.0

-2.0

-1.0

1.0

2.0

3.0

16%

68%

16%

2.5%

95%

2.5%

0.5%

99%

0.5%
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Value-at-Risk
Defined

Value-at-Risk (VaR) is a measure of the maximum

potential change in the value of a portfolio of
instruments with a given probability over a pre-set
horizon (RiskMetrics, 1996, p. 6).
A stock has a monthly and monthly

Assuming normality the Value-at-Risk (VaR) is

There is a 2.5% probability to experience a loss of 6.91% or more in
the next month.
2 x STD

Based on the empirical rule of the

normal distribution, 5% of
observation lie two STDs or more
from the mean. As the normal
distribution is symmetric, area in
left tail below -0.0691 is 2.5%
-0.0691

0.0151

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Value-at-Risk
Value-at-Risk (VaR) is a measure of the maximum
potential change in the value of a portfolio of
instruments with a given probability over a pre-set
horizon (RiskMetrics, 1996 p. 6).
VaR measures risk
By change, they mean loss
VaR is generally reported as a dollar value, but can be reported
as a percentage.
Can handle portfolios and considers diversification benefit.
Can be reported for a range of probabilities (most commonly
95% and 99%).
Can be for any investment horizon, but generally short-term,
e.g. 1-day to 10-days .
Requires some knowledge, assumption or simulation related to
the distribution of returns
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Value-at-Risk
Method

Detail

Historical
Simulation

From sample of returns, find the return that

corresponds to the VaR percentile.
ADV: Does not assume distribution
DISADV: Delayed response to changes in volatility
and can become difficult to calculate in large
portfolios as factors used to price assets increase.

Normal

Assume normality of returns, which requires

estimates of return mean and variance.
ADV: Easy to calculate and can be adjusted for
changes in volatility
DISADV: Does not capture fat-tails, not suited to
some assets (e.g. options), requires large number of
correlations in large portfolios
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Value-at-Risk
Historical Simulation
Portfolio revalued under historical return distribution over
some lookback period (e.g. 1 year or 252 days).
Use excel function percentile, =percentile(data, percentile)
Order data and find observation that corresponds to
percentile. For example, 1000 returns and calculating the
VaR(99%), use the average of the 10th and 11th worst returns.
Why not 10th worst returns? Because the percentile
ensures that there is the set percentage of observations
below the point corresponds to the percentile.
When the observations related to the percentile is an odd
number, use the next observation. For example, 3900 x
0.01 = 39, need to use 40th observation.

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Value-at-Risk

Used full sample period to estimate

VaR.

Generating this graph takes a bit o

effort. Its an bar chart of the retu
dist. With VaR(95%) and VaR(99%
added as line charts.

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Value-at-Risk
Dollar VaR (VaR$)

From earlier, VaR is generally reported as a dollar value.

Therefore, the daily VaR(95%) for $1,000,000 CBA position
would be

The VaR$ is reported without the negative sign as the

generally understanding is that VaR$ refers to a loss.
Accordingly,

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Value-at-Risk
Normal VaR:

Where: is the probability of experiencing a loss greater than the VaR

is the time horizon
and are estimated from sample data ( and )
is the inverse of the normal cumulative density function (CDF), i.e. it
gives the z-score the corresponds to probability. Use the excel
function
=normsinv(prob.) or the inverse normal tables.

Note:
at the daily frequency, we will generally assume that when
calculating VaR.
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Value-at-Risk

Comments:
The Normal VaR(95%) is somewhat close to HS VaR(95%).
The same cannot be said for the VaR(99%). The Normal
VaR(99%) sits well inside the HS VaR(99%). Why?
The return distribution is not normal, it is leptokurtic. That
is, it has a higher peak than the normal distribution and,
importantly, fatter tails. Hence, the normal distribution does
not have sufficient probability mass in the tails. This is also
noted in the number of exceedances (the number of returns
worse than VaR) for the VaR(99%) being much greater than
1%. Note that the sample period also includes the GFC.
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Value-at-Risk

Good old
GFC
Increased
volatility,
increased VaR
exceedances.
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Value-at-Risk
To date, the analysis has used the full-sample. This has
two obvious limitations.
1. It includes the GFC, so the percentile and standard deviation
are relatively large over the full sample. This is noted by the
relatively small number of VaR exceedances before the GFC.
2. When VaR is estimated, it relates to upcoming periods. That
is, it is a forecast! When looking at calculating VaR and
measuring its performance, we should use the data in the
same manner as if we were using it in practice.

To overcome these limitations, we will use a 1-year or 252

day lagged rolling window to estimate the HS and Normal
VaRs.
. For example,
VaR at day 253 will use returns from days 1 to 252
VaR at day 254 will use returns from day 2 to 253
VaR at day t will use the returns for t-252 to t-1

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Value-at-Risk

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Value-at-Risk

exceedances are clustering around the GFC. In part, this is because the rolling w
means that VaR is slow to update to the changing volatility environment.
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Value-at-Risk
Normal VaR with Time Varying Volatility

Where: comes from the EWMA model

Where:
is the sample variance

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Value-at-Risk

Better

25

Value-at-Risk

The exceedances to VaR cluster between 08-10, which corresponds to

GFC, when the model is not working. Exceedances to VaRt do not
cluster, theyre spread over the sample as model is capable of
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updating to the changing volatility environment.

Value-at-Risk
Basel Traffic Lights
Summarises the quality of a model in terms of the
colours of a traffic light. For example, the VaR(99%)
requirements are
Green:
Yellow:
Red:

Exceedances 4 in last 250 days

5 Exceedances 9 in last 250 days
10 Exceedances in in last 250 days

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Value-at-Risk
Applications:
1.
2.
3.
4.

Market Risk Limits

Calibrating Valuation and Risk Models
Performance Evaluation
Regulatory Reporting, Capital Requirement

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Value-at-Risk
Market Limits:
Prior to VaR, trading limits were set on a nominal or
equivalent values, e.g. $100m, that was only indirectly
related to risk.
Limits based on VaR$ are a direct function of risk.
Moreover,
It is meaningful value that relates to the amount that
can be lost over a given horizon for a given probability.
As a standardised measure, different
securities/exposures can be directly compared.
Aggregates to overall VaR$ for the entire portfolio. In
doing so, can capture diversification benefits. More
next lecture
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Value-at-Risk

RiskMetrics, 1996 p.35.

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Value-at-Risk
Regulatory Reporting, Capital Requirements:
Banks are required to hold an adequate amount of capital to
cover expected losses.
The basic rule has been the capital should be no less than
8% of risk-weighted assets:
Capital includes equity, retained earnings and
subordinated debt
Risk-weighted assets means that different assets have
different capital requirement. For example, in Basel II the
risk weight for AAA government securities were 0% (so no
need to hold capital as governments never ever default,
right), AAA corporate securities were 20% (this includes
the senior tranche in mortgage backed securities), home
loans were 50% and loans to businesses were 100%.
Example: $100 Greek Government bond required $0
capital while $100 loan to BHP required $8 of capital.
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Value-at-Risk
Alternatively, assets that were part of a banks trading book
could be aggregated to take into account diversification
benefit and their capital charge determined from Value-at-Risk.

where:

if in green zone
if in yellow zone, where X is no. of exceedances
if in red zone

is an adjustment to reflect the underlying credit risk of the portfol

The smaller your VaR, the smaller your market risk charge and
the greater the return on capital. However, if you consistently
underestimated VaR the penalty factor, would increase.
Moreover, the regulator request corrective action if in the red
zone. Note that these zones are known as the Basel Traffic
Lights.
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Value-at-Risk
Criticisms
Brown, A. and Einhorn, D. (2008, June/July), Point/Counterpoint.
Global Association of Risk Professionals Risk Review, pp.10-26.
http://www.garpdigitallibrary.org/download/GRR/2012.pdf
Einhorn:
VaR ignores what happens in the tails creates a false sense of
security among senior managers and watchdogs p.11.
My impression of this is that the large broker-dealers convinced the
regulators that the dealers could better measure their own risks, and
with fancy math, they attempted to show that they could support more
risk with less capital p. 16.
, I believe that the outlook for Lehmans stock is dim p.18. (doesnt
use VaR)

Brown:
There were all sorts of candidates for a risk-sensitive measure VaR
has only one virtue, but it was enough to win out over all the others.
VaR is observable p.19.
VaR is only as good as its backtest p. 20.
VaR is a tool of risk management, not risk measurement p. 20.
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Value-at-Risk
Criticisms

where is portfolio of and combined.

This is know as the subadditivity problem and occurs
when an extreme event that does not enter the or
(its in the tail past the VaR) enters . Hence, .
From our understanding of diversification, you would
expect that .
However, it is argued that subadditivity is not a major
problem and should not be used as the reason to
abandon VaR for an alternative risk measure.
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