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Original Draft Copy - VaR and VaR Derivatives

Original Draft Copy - VaR and VaR Derivatives

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Original draft copy written in 1994. Please note that the contact info in this document is no long valid.
Original draft copy written in 1994. Please note that the contact info in this document is no long valid.

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Published by: Ralph Y. Liu, 刘冶民 on Aug 09, 2009
Copyright:Attribution Non-commercial


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 Mailing Address: Tanglin P.O. Box 0391, Singapore 912414 Headquarters Address: 400 Orchard Road, #17-06 Orchard Towers, Singapore 238875Tel: (65)734-9803, 734-9804, 738-1747; Fax: (65)734-0392armspl@singnet.com.sg (Sales & Technical Support)acmltd@singnet.com.sg (Administration)arms@pacific.net.sg (Management)
 July 27, 1996
VaR and VaR Derivatives
Pretty soon you may hear the following conversation between an eager structuredderivatives dealer with his or her curious customer:Dealer: “Why don’t you try selling some VaR (Value at Risk) Calls to finance the costto purchase the VaR Puts? You may adjust the confidence levels, which are your strike prices,so that you can have a zero-cost VaR Range Forward.”“What is my downside protection vs. my upside profit potential?” the customer asked.Dealer: “It depends on whether you use spot level or forward level as your benchmark (the expected return). Let’s assume that you choose to use your portfolio implied forward asthe benchmark, then your two strike levels would be quite symmetrical, such as 80% vs. 20%or 70% vs. 30% etc. In the lingo of a two-tail distribution, your portfolio’s P&L could belocked in to be within two standard deviations to each side of your expected return. Forexample, your portfolio’s profit and loss could be confined to plus and minus five million USDollars on the horizon date.”Customer: “Will I have to stop trading during this period?”
Dealer: “Well, our pricing will be much better for a ‘locked-up’ portfolio. But we canmake a price for a dynamic portfolio as well if that suits you better.”In a couple of years’ time a conversation like this may not sound as exotic as it maysound now. VaR has been gaining its status as the de facto measure for market risk. It is notonly the regulators who are getting to endorse it one after another, all private sector financialinstitutions are also embracing it. In what many view as the driving factor for the beginningof a new risk management industry, the VaR revolution has gradually been penetrating alllevels of management of many financial institutions throughout the world.
I. What is VaR (Value at Risk)? 
The VaR approach represents a set of methodologies to measure market risks. Theconcept is not new. In fact, many financial institutions around the world have been practicingsome sort of Value at Risk (money at risk or dollar at risk, as they were known by differentnames before) procedures to manage their trading books in the past. However, the systemicapproach of the VaR concept was first brought to the financial world’s attention by the Groupof Thirty (G30) in their Recommendations for Derivatives Practices and Principles publishedin July, 1993. As it stands right now, the VaR is only used to measure market risk, althoughproposals have been raised to implement the same concept to measure credit and evenoperational risks.VaR is basically a statistical estimate which measures, at a certain confidence interval(say 95%), the amount of value (5 million) in a certain currency (Hong Kong Dollar) that aportfolio or an organization may stand to lose within a certain horizon time period (10 days)due to the potential changes in the market prices of the underlying assets. The possible timehorizons for analysis could be only one day for most trading positions or it could be a monthor longer for an investment portfolio.
 VaR has become significant because it represents the first collective effort by themarket participants and regulators to create a standardized approach to assess risks, whether itis for a particular security, an investment portfolio or the entire balance sheet of anorganization. However, it is very important to emphasize that VaR is only a statisticalestimate usually based on an assumed distribution of some historical time series data. It is aforecast number and can not by nature be accurately determined with 100% degree of confidence. The common types of methodologies used to calculate this estimate number are:
1. Historical Price Modeling
In historical price modeling, one tries to construct a distribution of portfolio returnsfrom a series of changes in portfolio values based on a given time series of historical marketprices of basic component instruments such as FX, interest rates, stocks and commodities atthe beginning and the end of a given time horizon. From the distribution of the portfolioreturns we can calculate the potential portfolio loss, at a certain confidence interval, for aparticular holding period.Having the time series of portfolio returns, many statistical techniques could be usedto construct the distributions to determine the probability of loss for the portfolio. Forexample, if we assume the portfolio returns follow a normal distribution through time, theVaR under any level of confidence can be easily calculated from the product of a confidencelevel factor and the standard deviation of the portfolio returns distribution.(See Figure 1) 
2. Estimated Variance and Covariance Method
A more pragmatic and convenient approach is to create a series of historical varianceand covariance matrix data on simplified financial instruments and then apply them to thosecomponent securities in a portfolio. Most portfolio risk factors can be broken down intoequivalent simplified instruments such as FX spot rates, money market rates, governmentbond prices, swap rates, stock market indices and commodities prices.

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