VALUE AT RISK (VAR) MEASURE

IT IS A STATISTICAL MEASURE OF THE

MAXIMUM POTENTIAL LOSS FROM UNCE-
RTAIN EVENTS IN THE NORMAL BUSINE-
SS OVER A PARTICULAR TIME HORIZON.
IT IS MEASURED IN UNITS OF CURRENCY
THROUGH A PROBABILITY LEVEL. IT IS
THE LOSS MEASUREMENT CONSISTENT
WITH A CONFIDENCE LIMIT SUCH AS
99% ON A PROBABILITY DISTRIBUTION.
11 July 2013 PROF D. GOPINATH 1
 VAR MEASURE
IT IMPLIES THAT THIS IS THE MEASUREM-
ENT OF A LOSS WHICH HAS A CHANCE
OF ONLY 1% OF BEING EXCEEDED. THAT
MEANS IF A TRADER MIS HEDGES A DEAL
IT IS A MUST TO KNOW THE CHANCES
OF LOSS BEFORE THEY OCCUR. VAR IS
DEFINED AS THE MAXIMUM LOSS A
PORTFOLIO OF SECURITIES CAN FACE
OVER A SPECIFIED TIME PERIOD WITH A
SPECIFIED LEVEL OF PROBABILITY.
11 July 2013 PROF D. GOPINATH 2
 VAR- MEASURE
EX:- A VAR OF $1 MILLION FOR A DAY AT A
PROBABILITY OF 5% MEANS THAT THE
PORTFOLIO TRADED SECURITIES WOULD
EXPECT TO LOOSE AT $1 MILLION IN
ONE DAY WITH A PROBABILITY OF 5%.
ALTERNATIVELY THERE IS 95% PROBAB-
ILITY THAT THE LOSS FROM THE PORTF-
OLIO IN ONE DAY SHOULD NOT EXCEED
$1 MILLION.
11 July 2013 PROF D. GOPINATH 3
 VAR- MEASURE
SO LOSSES MAY OCCUR ONCE IN 20 TRAD-
ING DAYS.VAR ACTUALLY ASSIGNS A PR-
OBABILITY TO A DOLLAR AMOUNT OF
HAPPENING OF THE LOSS.IT IS NOT THE
MAXIMUM LOSS THAT COULD OCCUR
BUT ONLY A LOSS AMOUNT THAT COULD
EXPECT TO EXCEED ONLY AT SOME PER-
CENTAGE OF TIME. THE ACTUAL LOSS
THAT MAY OCCUR COULD BE MUCH
HIGHER THAN AT VAR.
11 July 2013 PROF D. GOPINATH 4
APPROACHES TO COMPUTING VAR
THERE ARE VARIOUS APPROACHES TO
COMPUTING VAR, THE MOST IMPORTA-
NT ONES ARE:-
 THE VARIANCE CO-VARIANCE
APPROACH
 HISTORICAL SIMULATION APPROACH
 MONTE CARLO SIMULATION APPROACH

11 July 2013 PROF D. GOPINATH 5

 VAR-VARIANCE COVARIANCE APP
THIS ALLOWS AN ESTIMATE TO BE MADE
OF THE POTENTIAL FUTURE LOSSES OF A
PORTFOLIO THROUGH USING STATISTI-
CS ON VOLATILITY OF RISK FACTORS IN
THE PAST AND CORRELATIONS BETWEEN
CHANGES IN THEIR VALUES. VOLATILIT-
IES AND CORRELATION RISK FACTORS
ARE CALCULATED FOR A SELECTED
PERIOD OF HOLDING THE PORTFOLIO.
11 July 2013 PROF D. GOPINATH 6
 VAR-VARIANCE-COVARIANCE APP
THIS IS DONE USING HISTORICAL DATA.
VAR IS COMPUTED AS MULTIPLYING
EXPECTED VOLATILITY OF THE PORTFO-
LIO BY A FACTOR THAT IS SELECTED
BASED ON THE DESIRED CONFIDENCE
LEVEL.THIS IS BASED ON THE ASSUMPT-
ION THAT THE UNDERLYING MARKET
FACTORS FOLLOW A MULTIVARIATE
NORMAL DISTRIBUTION.
11 July 2013 PROF D. GOPINATH 7
 VAR-VARIANCE COVARIANCE APP
AS THE PORTFOLIO RETURN IS A LINEAR
COMBINATION OF NORMAL VARIABLES
IT IS ALSO NORMALLY DISTRIBUTED.
THE NORMAL VAR IS EASY TO HANDLE
BECAUSE THE VAR MULTIPLE OF THE
PORTFOLIO STD DEVIATION AND THE
PORTFOLIO STD DEV IS THE LINEAR
FUNCTION OF INDIVIDUAL VOLATILITIES
AND COVARIANCES.
11 July 2013 PROF D. GOPINATH 8
 VAR- VARIANCE COVARIANCE APP
THE FOLLOWING FACTS ARE TO BE CONSI-
DERED.1.MOVEMENTS IN MARKET
PRICES DO NOT ALWAYS FOLLOW A
NORMAL DISTRIBUTION THEY SOMETIME
EXHIBIT HEAVY TAILS, WHICH MEANS A
TENDENCY TO HAVE A RELATIVELY MORE
FREQUENT OCCURRENCE OF EXTREME
VALUES THAN FOLOWING A NORMAL
DISTRIBUTION.
11 July 2013 PROF D. GOPINATH 9
 VAR- VARIANCE COVARIANCE APP
2. MODELS MAY NOT APPROPRIATELY
DEPICT MARKET RISK ARISING FROM
EXTRAORDINARY EVENTS.
3. THE PAST IS NOT ALWAYS A GOOD
GUIDE TO THE FUTURE FOR EXAMPLE
CORRELATION FORECAST MAY NOT
HOLD TRUE.

11 July 2013 PROF D. GOPINATH 10

 VAR- HISTORICAL SIMULATION
APPROACH
THIS APPROACH USES HISTORICAL DATA
OF ACTUAL PRICE MOVEMENTS TO
DETERMINE THE ACTUAL PORTFOLIO
DISTRIBUTION. IN THIS WAY THE
CORRELATIONS AND VOLATILITIES ARE
IMPLICITLY HANDLED.THE ADVANTAGE
HERE IS THAT THE FAT TAILED NATURE
OF SECURITY’S DISTRIBUTION IS
PRESERVED.
11 July 2013 PROF D. GOPINATH 11
 VAR- HISTORICAL SIMULATION
APPROACH
FAT TAILS REFER TO THE FACT THAT THE
LARGE MARKET MOVES OCCUR MORE
FREQUENTLY THAN WHAT WOULD
OCCUR IF THE MARKET RETURNS WAS
NORMALLY DISTRIBUTED.IN USING
HISTORICAL SIMUALTION CHANGES
THAT HAVE BEEN SEEN IN RELEVANT
MARKET PRICES AND THE RISK FACTORS
ARE ANALYZED OVER 1 TO 5 YEARS
TIME.
11 July 2013 PROF D. GOPINATH 12
VAR- HISTORICAL SIMULATION
THE PORTFOLIO UNDER EXAMINATION IS THEN
VALUED USING CHANGES IN THE RISK
FACTORS DERIVED FROM THE HISTORICAL
DATA TO CREATE THE DISTRIBUTION OF THE
PORTFOLIO RETURNS.WE THEN ASSUME THAT
THIS HISTORICAL DISTRIBUTION OF RETURNS
IS ALSO A GOOD PROXY FOR THE DISTRIBUTI-
ON OF RETURNS OF THE PORTFOLIO OVER
THE NEXT HOLDING PERIOD.

11 July 2013 PROF D. GOPINATH 13

 HISTORICAL SIMULATION
THE RELEVANT PERCENTILE FROM THE
DISTRIBUTION OF HISTORICAL RETURNS
LEADS TO THE EXPECTED VAR FOR THE
CURRENT PORTFOLIO. OF COURSE IF
ASSET RETURNS ARE NORMALLY DISTRI-
BUTED THE VAR OBTAINED UNDER THE
HISTORICAL SIMULATION APPROACH
SHOULD BE THE SAME AS THAT UNDER
VARIANCE-COVARIANCE APPROACH.
11 July 2013 PROF D. GOPINATH 14
 MONTE CARLO SIMULATION
APPROACH
TO APPLY THIS APPROACH FIRST WE HAVE TO
CALCULATE THE CORRELATION AND
VOLATILITY MATRIX FOR THE RISK FACTORS.
THEN THESE CORRELATIONS AND
VOLATILITIES ARE USED TO DRIVE A RANDOM
NUMBER GENERATOR TO COMPUTE CHANGES
IN THE UNDERLYING RISK FACTORS. THE
RESULTING VALUES ARE USED TO RE-PRICE
EACH PORTFOLIO POSITION AND DETERMINE
TRIAL GAIN OR LOSS.

11 July 2013 PROF D. GOPINATH 15

 MONTE CARLO SIMULATION
APPROACH
THIS PROCESS IS REPEATED FOR EACH
RANDOM NUMBER GENERATION AND RE-
PRICED FOR EACH RANDOM NUMBER
GENERATION AND REPRICED FOR EACH
TRIAL.THE RESULTS ARE THEN ORDERED
SUCH THAT THE LOSS CORRESPONDING
TO THE DESIRED CONFIDENCE LEVEL
CAN BE DETERMINED.

11 July 2013 PROF D. GOPINATH 16

 MONTE CARLO SIMULATION
APPROACH
MONTE CARLO SIMULATION CAN BE
VIEWED AS A HYBRID OF THE VARIANCE
COVARIANCE APPROACH AND THE
HISTORICAL SIMULATION APPROACH. IT
USES THE VARIANCE COVARIANCE MATR-
IX TO DRIVE A SIMULATION.THIS SIMUL-
ATION WORKS SIMILAR TO THE HISTOR-
ICAL SIMULATION BUT RATHER THAN
SIMPLY USING HISTORY IT CREATES THE
HISTORY (KNOWN AS PATH).
11 July 2013 PROF D. GOPINATH 17
 MONTE CARLO SIMULATION
APPROACH
IT IS BASED ON THE VARIANCE COVARIAN-CE
MATRIX DEVISED FROM THE ACTUAL HISTORIC
MARKET DATA. THE GREATEST BENEFIT OF
THE MONTE CARLO SIMULA-TION VAR IS THE
ABILITY TO USE PRICI-NG MODELS TO
REVALUE NON-LINEAR SECURITIES FOR EACH
TRIAL. IN THIS WAY THE NON LINEAR EFFECTS
OF OPTION THAT WERE MISSED IN THE
VARIANCE COVARIANCE VAR CAN BE CAPTUR-
ED IN THIS APPROACH.

11 July 2013 PROF D. GOPINATH 18

 MONTECARLO SIMULATION
APPROACH
MONTE CARLO SIMULATION HAVING ITS ROOTS
IN RANDOM NUMBER GENERATI-ON IS
EXPOSED TO SAMPLING ERROR. THERE IS THE
RISK OF RUNNING TOO FEW SIMULATIONS TO
ADEQUATELY CAPTURE THE DISTRIBUTION
AND THIS COULD RESULT IN AN INFERIOR
ANSW-ER.HOWEVER METHODS EXIST TO
ESTIMATE HOW FAR OFF A SIMULATION IS SO
THAT WE CAN DECIDE WHETHER TO RUN OR
NOT TO RUN TRIALS.

11 July 2013 PROF D. GOPINATH 19