Risk Management and

Derivatives
Lecture 04:
Value-at-Risk 2

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 1
Week 7: Forwards and Futures 2
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
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Week 14: Revision

Lecture Outline
Review of VaR
Portfolio VaR
Individual Stock Return Statistics and VaR
Portfolio Statistics and VaR
Time-varying Correlations

VaR Horizons
Return and Standard Deviation Adjustments

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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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

Value-at-Risk
Normal VaR with and without time varying volatility

Where: is the unconditional STD and is the conditional STD

, where

is the sample variance

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Value-at-Risk

Better

Portfolio VaR
Portfolio VaR

If we can replace the returns of the individual asset with the

returns of the portfolio, we can calculate HSVaR of the
portfolio.
If we can replace the mean and standard deviation of the
individual asset with the mean and standard deviation of the
portfolio, we can calculate the NVaR of the portfolio.
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Portfolio Theory
Calculating Portfolio Returns

where:
is the proportion of wealth invested in
asset i
because of the budget constraint

N = 2:

N = 3:

e that this is the portfolio log return approximation. RiskMetrics (1996, pp.48-49
justifies the use of this approximation.
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Portfolio Theory
Calculating Portfolio Expected Returns

where:
is the proportion of wealth invested in
asset i
because of the budget constraint

N = 2:

N = 3:

Portfolio Theory
Calculating Portfolio Return Variance

where: is the proportion of wealth invested in asset i

because of the budget constraint

N = 2:
N=3

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Portfolio VaR
Portfolio example

N = 3:
CBA, TLS and BHP
Download:yahoofinance.com
Merge Data: Date and Adjusted Close Price.
Clean Data: Remove any day where 1 or more stocks do
not trade.
For example, we will remove a day when
CBA and TLS
trade but BHP does not.
Returns:
Daily Log Returns
Statistics:
Unconditional Mean, Standard Deviations
and
Correlations
VaR:
Individual stock and portfolio (weights detailed
later)

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Portfolio VaR
Plot of BHP closing price and associated log
Returns.
Whats happened in the middle of 2001?
On 29 June 2001 BHP merged with Billiton:
Read this announcement
This artefact must be removed from the
data as the change in price does not reflect
a change in value as shareholders were
entitled to 1.06 bonus shares (refer article).
What to do?

Here, we simply use adjusted returns provide

by yahoofinance.
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Portfolio VaR

13

Portfolio VaR

Dates not aligned

This then flows through
spreadsheet

orrect: Create a new date row that starts at the first date and then includes all d
uding weekends trust me) until the last observation. Then use the excel functio
ookup(lookup values, data, column, FALSE)
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Portfolio VaR

peat for CBA and TLS. Then remove any date where there is a #N/A. This can be
multiplying the 3 prices on a given day together as #N/A is returned if a #N/A
15 will f
resent on that day. TIP: copy, paste special dates as values otherwise filter

Portfolio VaR

Tip: once happy with prices, copy and

paste special values to remove the
10,000+ vlookup formulas. This will stop
Your excel from crashing (a much less
formal term is often used in finance)
Still to do calculate returns and their statistics.
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Portfolio VaR

Interestingly, the returns seem to display a relatively low level of

correlation.
Intuition indicates that this reflects the diversity of the stocks
selected.

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Portfolio VaR

Exceedances for all three stocks follow results from last weeks lecture.
That is, too few exceedances at the 95% level and too many at the 99% level.
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Portfolio VaR
Portfolio Statistics

he portfolio will consist of 30% BHP, 60% CBA and the remainder in TLS (thats
1
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Portfolio VaR

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Portfolio VaR

n at only

N=3, the calculation is difficult and prone to error. There is a

hematical techniques that makes this calculations a lot easier and less prone to
ear algebra / matrix operations), but it is beyond the scope of this unit.

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Portfolio VaR

portfolio VaR is less than the weighted average of the individual VaRs because
he diversification benefit that arises from investing across stocks that are not pe
itively correlated. Whats the benefit of the reduced VaR?
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Portfolio VaR

der that has a daily limit of VaR$ = 20,000 can increase the exposure to the port
e the amount of the individual assets. As a result, the annual dollar expected ret
500 higher than any other asset. This includes the asset with the highest expecte
n. Given the weights of the portfolio and the portfolio size, the individual VaRs fo
portfolio are:

$25,503.34
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Portfolio VaR

nce again, it is evident that volatility is not constant. The VaR could be updated t
eflect the changes in volatility.

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Portfolio VaR

25

Portfolio VaR

26

Portfolio VaR

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Time-Varying Correlations
Given that variance of asset returns are time varying,
it is likely that the correlation of asset returns are also
time varying.
Capturing the time-varying nature of correlation is
important because it is correlation that drives
diversification benefit. This benefit directly flows
through to VaR by reducing the portfolios return
standard deviation.

where

How do we measure correlation?

How do we measure time-varying correlation

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Time-Varying Correlations
To measure time-varying correlations, we simply

measure the time-varying variances and covariance.

To measure the time-varying covariance, , we apply an
EWMA model to product of asset returns () at each
point in time.

where and the unconditional covariance is used as .

Note, the number of unique covariances grows quickly

with N; . For our N=3, it means there are 3 x 4 / 2 3
= 3 unique covariance; BHP and CBA, BHP and TLS,
and CBA and TLS. For N = 10, its 45 covariances.
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Time-Varying Correlations
Some detail

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Time-Varying Correlations
Some detail

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Time-Varying Correlations

time-varying correlations provide some interesting results. First, correlation is no

tant. Second, the model used provides a very noisy estimate of correlation, as n
he spikes into the negative regions. Third, the correlations increase prior to the G
ease during the GFC. This is somewhat surprising and would require further
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stigation before making definitive comments.

VaR Horizons
All of the VaRs considered thus far have had a horizon of
1-day. But theres no reasons, and in fact there are some
very good reasons, why VaR cannot be calculated over
longer horizons. For example, the Market Risk Charge
applied to a banks trading book uses a 10-day VaR.
How do we adjust for longer horizons?
1.

Use returns over the longer horizons. This either requires more
data or creates issues with overlapping returns.

2.

If using a Normal VaR, we can simply adjust the expected return

and standard deviation for longer time frames. In doing so, we
assume that returns are uncorrelated through time (they display no
significant auto-correlation, it relates to market efficiency).
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VaR Horizons
Returns over longer horizon:

1-day Log Return:

2-day Log Return:

k-day Log Return:

e: log return are additive but simple (relative) returns are not. Refer RiskMetrics
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VaR Horizons
Variance Adjustment:

1-day Variance:
2-day Variance:

k-day Variance:

Standard Deviation Adjustment

k-day Stanadard Deviation:

ote: we are assuming that the returns (not the squared returns) are uncorrelated
rough time. This is evident by the lack of any covariance terms above.
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VaR Horizons
Portfolio Normal VaR at different horizons

1-day N VaR:
2-day N VaR:
k-day N VaR:
Note: this also applies to Normal VaR for individual assets.

Normal VaR for k=1, 2 and 10 based on unconditional standard deviatio

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