Value-at-Risk (VaR)

• For risk management purposes, it might be useful to estimate how

much money your portfolio might lose over a given time span and a
certain confidence level.

• VAR is defined as VAR (holding period; 1 – α) where 1 – α is your

confidence interval.

• If VAR (30-day; 95%) = $10,000 then in 95 out of 100 months the

change in the value of your portfolio will be less than $10,000.

• Note that this tells you nothing about the magnitude of potential
losses in extreme cases. Use expected shortfall rather than VAR for
such cases.
 Graphically

-V $0 Change in the value

of the portfolio

• The most difficult part is to understand the nature of risks that your portfolio is
exposed to and figuring out its expected loss distribution.
 How to calculate VAR in EXCEL?
VaR  
1
N (X )
where X is the confidence level,
 is the standard deviation of the portfolio change over the time horizon,
1
N (.) is the inverse cumulative normal distribution (NORMSINV function in EXCEL)

The assumption behind this formula is that changes in the value of your portfolio is
normally distributed (not always a good assumption).

The formula shows that regardless of the time horizon, VaR is proportional to  .
 How to choose the time horizon

• The time horizon can differ from a few hours for an active trading
desk to one month for a pension fund.

• How to compute T-day VaR using 1-day VAR?

(1) T-day σ = 1-day σ x √T
(2) VaR = σ x N-1(X)

• From (1) and (2) it’s easy to show that T-day VAR = 1-day VAR x √T

• We assume that the value of the portfolio on successive days have

independent identical normal distributions with mean zero (i.e., no
autocorrelation)
 The role of autocorrelation

• If daily changes in portfolio values are first-order autocorrelated

(shown by ρ) then T-period variance based on daily variance (σ)
becomes:

[T  2(T  1)   2(T  2)   2(T  3)   ...  2  ]

T 1

2 2 3

• The ratio of T-day VAR to 1-day VAR for different autocorrelations:

ρ T=1 T=2 T=5 T=10 T=50 T=250

0.00 1.00 1.41 2.24 3.16 7.07 15.81
0.05 1.00 1.45 2.33 3.31 7.43 16.62
0.10 1.00 1.48 2.42 3.46 7.80 17.47
0.20 1.00 1.55 2.62 3.79 8.62 19.35
 How to choose the confidence level

• Suppose that a bank wants to maintain a AA credit rating and

calculates that banks with this rating have a 0.03% chance of
defaulting over a one-year period. So, for risk management
purposes, the bank may choose a one-year horizon and 99.97%
confidence level for the VaR analysis.

• If VaR(1-year, 99.97%)=$5 billion, then banks with $5 billion equity

have a 0.03% probability to become insolvent.

• VaRs based on different confidence can be converted to each other,

assuming the loss distribution is normal.
1 *

VaR ( X )  VaR ( X )
* N (X )
1
N (X )
 Back-testing

• Testing how past VaR estimates performed

• Suppose 100 days ago we estimated VaR(1-day,99%)=$10,000.

• By back-testing, we can examine how many times over the last 100
days our losses exceeded $10,000. If our estimation is perfect, we
should find that only once…

• One issue with back-testing is portfolio composition is actively

changed by traders over time, so it makes more sense to conduct
back-testing on a hypothetical passive portfolio.
 A more formal way to back-test

• Suppose you compute VaR(1-day, X%)

• Then the probability of the VaR being exceeded is p = 1 – X/100
• Suppose we look back n days and observe that the VaR is exceeded m
days
• Also, suppose that m/n>p
• Should we reject the model for producing values of VaR that are too low?

• We can use binomial distribution to estimate the probability of the VaR

being exceeded m or more days (use BINOMDIST function in Excel):
n
n!
p (1 p)
nk

k

k  m k!( n  k )!
 Example

• Suppose that we back-test a VaR model using 600 days of data.

The VaR confidence level is 99% and we observe 9 exceptions. The
expected number of exceptions is 600 x (1-99%)=6. Should we
reject this model?

• The probability of 9 or more exceptions can be calculated in EXCEL

as 1-BINOMDIST(8,600,0.01,TRUE) = 0.152.

• So, at a 5% confidence level, we should not reject our model.

• However, if number of exceptions were 12, we would have rejected

our model because 1-BINOMDIST(8,600,0.01,TRUE) = 0.019.
 A simple example

• Consider a portfolio manager who manages a portfolio which

consists of a single asset. The return of the asset is normally
distributed with annual mean return 10% and annual standard
deviation 30%. The value of the portfolio today is $100 million. We
want to answer various simple questions about the end-of-month
distribution of portfolio value:

1. What is the probability of a loss of more than $20 million dollars by

month end (i.e., what is the probability that the end-of-month value is
less than $80 million)?

2. What is the VAR at the 99% confidence level?

 First question
• If you lose $20 million, your annual return is -20%. So, you want to
know P(r < -20%). But how can you compute this?

• One thing that you can do is to use the probability density function
associated with normal distributions
 (x) 
 2

1
f ( x)  exp  
2 
2
 2 


• Remember, r is a normally distributed random variable with μ=10%

and σ=30%, π = 3.14159, and e=2.71828. So,
 Graphically
1  (r 0.1)2 
f (r )  exp  
0.3 2(2.71828)  2(0.3) 
2

f(r)  

r=-20% μ=10%
r

Shaded region: P(r < -20%)

 Integration
 0.2
1  ( r  0 .1)
2

exp  dr
So, we need to solve for
 0.3 2(2.71828)  2(0.3)  2

 
 Is there an easier way to compute
P(r < -20%)?
• Certainly there is!

• We’ll transform r to a standard normal variable z and examine the z-

table rather than doing integrals?

• The idea is as follows: Every value of a random variable r ~ N (μ, σ)

can be transformed to z ~ N (0, 1) by using
r
z

 20%  10%
• So, if r=-20% then z  30%
 1.0

• Then, P(r < -20%) = P(z < -1)

The z-table
 Answers

• So, based on the z-table we find that P(r < -20%) or put differently
P(Losses>$20,000) = 15.87%.

• The second question is VAR(1-year; 99%)=?

– Go to the z-table and find the value that satisfies P(z < ?) = 1%.
• z = -2.33

r  10%
– What is the r associated with z=-2.33?  2.33, r  59.9%
30%

– If starting portfolio value is $100,000 and r = -59.9%, then loss = $59,900.

• VAR(1-year; 99%)=59,900.
 VAR vs. Expected Shortfall

• As I said before, VAR tells us nothing about the magnitude of

potential losses in extreme cases. We use expected shortfall (or
conditional VAR) rather than VAR to estimate how bad things could
go.

• Suppose that a bank tells a trader that one-day 99% VAR of his
portfolio should not exceed $10 million. The trader can construct a
portfolio where there is a 99.1% chance that daily losses are less
than $10 million and a 0.9% chance that it is $500 million.

• Because traders’ compensation is tied to returns that they generate,

they attempt to take hidden risks.
 Homework

• End of chapter problems 8.1, 8.3, 8.4, 8.5 (a, b, c, d), 8.6, 8.7, 8.9,
8.12, 8.13, 8.14