Value at Risk Intro

Value-at-Risk Intro March 2007
Juhani Huopainen
2007-2011 Juhani Huopainen (huopainen on gmail)
VALUE-AT-RISK
Schedule
1. What is VaR and what its not 2. VaR-methods 3. VaR-model: creation 4. VaR-metrics and their use
5. Advanced models
6. Stress tests and scenario analysis 7. Future challenges
1. What is VaR and what its not
Defining The Risk

Assume the trading position is composed of one long Q2 forward contract Price of the contract is 27 euros, underlying value 58.968 euros is this the total amount at risk? Is the risk the collateral requirement of the position? You have a sell stop-order in the markets at 26 euros. Is the risk 27-26 = 2.184 euros? What if you are addionally short a Q3 forward? is the total risk 123.883 euros? Or zero?
ENOQ2-07, 1.3.2005 - 26.1.2007
60.00 55.00
50.00
45.00
40.00
35.00
30.00
25.00
20.00 1 29 57 85 113 141 169 197 225 253 281 309 337 365 393 421 449 477 505 533 561 589 617 645 673 701 729 757 785 813 841 869 897 925 953 981
Risk is not equal to position size margin/collateral requirement stop-loss sum of individual risks
Defining VaR
VaR measures the largest expected loss over a certain period of time under normal market conditions at a certain confidence level.
A company can say that its daily trading VaR equals 1 million with 99% confidence level This means that under normal market conditions a loss larger than 1 million would on average happen once every hundred days.
example Q2-07, 1st Mar 2005 26th Jan 2007 (1000)
Well keep the presentation short and quickly calculate the correct VaR for one bought forward contract. We need the historical loss that is seen only once in hundred days Solution: we take 1000 daily forward returns, put them in ascending order and pick the tenth largest loss day (-4.65%) We do the same for 5% VaR and pick the 50th largest loss, -1.96%
ENOQ2-07, 1.3.2005 - 26.1.2007

60.00
55.00
50.00
45.00
40.00
35.00
30.00
25.00
20.00 1 29 57 85 113 141 169 197 225 253 281 309 337 365 393 421 449 477 505 533 561 589 617 645 673 701 729 757 785 813 841 869 897 925 953 981
4 5 6 7 8 9 10 11 12 13 14 15
-6.98% -6.44% -6.41% -6.08% -5.61% -5.48% -4.65% -4.62% -4.21% -3.93% -3.72% -3.67%
example Q2-07, 1st Mar 2005 26th Jan 2007 (1000)

Historical method what would have happened
500
Variance method: Mean zero, standard deviation 1.28% so 1% worst day would be -2.32635 * 1.28% = -2.98% ..and comparable 5% worst day
p5%: -1,96%
450
400
350
300
250
200
150
-1.64485 x 1.28% = -2.1%

p1%: -4,65
100
50
Difference? skew -1.37, kurtosis 12.7

-2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%
0 -7.00% -6.00% -5.00% -4.00% -3.00%
Already in trouble and only the 7th slide...
The bad and the good: Assumption: returns normally distributed Assumption: the correlations between different instruments is assumed to be stable. (we only had one instrument in our example, and still borked) Generally, tomorrow is assumed to be like yesterday Nonlinear instruments (e.g. options) do not fit into the model There is no single, official, correct VaR-method. This makes comparing the models or using the model outputs difficult VaR that deals with these weaknesses is bound to become complicated, heavy and still rely on other assumptions.
...but its not that bad
VaR is better than nothing VaR is better than the alternatives, especially when it is combined with limits and scenario analysis Portfolio theory is comfortable with only normally distributed world. More advanced VaR models do not suffer from this limitation Portfolio theory would think that playing lottery is very risky, as the potential payoff makes the results volatile. VaR thinks the risk is the possibility of losses, not profits VaR on is a simple dashboard figure that investors and regulators want and even management can understand. Like it or not, VaR has to measured
2. VaR-methods
History
Sharpe, Markowitz et al experimented with rudimentary VaR calculations already in 1950s, but lack of computational power made any practical applications unrealistic The end of Bretton Woods in 1971, oil crisis, inflation, volatility of the interest rates, government debt created new markets derivatives and their pricing were discovered: leverage became possible Bank risk profiling was oldfashioned +500 crude oil futures and -200 pork belly futures cannot be added by delta method By 1993 several banks had developed a proprietary VaR-method. Because of large derivative losses by many corporations and banks, J.P.Morgan published its own RiskMetrics-VaR RM VaR documentation and factor correlation data were free. JPMs idea was not to become a service provider, instead it wanted to trade derivatives with others
2. VaR-methods
Three main types

Variance-covariance method (VCV i.e. delta-normal) Historical simulation Monte Carlo simulation
10
2. VaR-methods
Parametric variance-covariance method
VCV-method: calculate historical returns and variances and covariances for all the instruments in the portfolio. Instead of full covariance matrix calculation, the problem can be solved by using only few variables (factors). In classical portfolio theory only the beta or codependence of a stocks price between a benchmark index is calculated, instead of all the covariances between all the individual stocks. These factors are identified and selected with the help of cluster analysis and PCA (principal component analysis) Assumption risk factors (and instrument price returns) are multivariate normal and the price of the portfolio is linearly dependent on these factors Assumption 2 the historical numbers give a good approximation of the future
11
2. VaR-methods

Expected return can be assumed to be an average of historical returns (?) Expected returns are usually not an issue, since they are a relatively small source of risk compared to variance of returns Variance can be estimated in many ways: long term average moving average (accounts for heteroscedasticity) GARCH (also accounts for mean reversion) EGARCH (also accounts for asymmetrical variance response) FIGARCH (also accounts for long-term memory effects) etc., etc. Variance clusters and is predictable to a certain extent
12
2. VaR-methods

Q3-07 ja Q2 07-forwards price correlation 0.98 and return correlation 0.88 Great, the example position on slide 3 (long/short) has a very small risk! Traditional VaR agrees with our intuition and we get a small number
15%
10%
5%
0%
-5%
-10%
-15%
-10%
-5%
0%
5%
10%
-15% 15%
13
Q3-07 ja Q2 07-forwards price correlation 0.98 and return correlation 0.88 Even a high correlation does not explain everything: R2=0.882=0.77
1.2
Short-term correlation is very volatile: 10-day corr varies between 0.1 and 1. Naive VCV-thinking gives us too too low VaR-number
0.8
0.6
0.4
10day 90day 180day
0.2
1/3/05
3/3/05
5/3/05
7/3/05
9/3/05
1/3/06
3/3/06
5/3/06
7/3/06
9/3/06
11/3/05
-0.2
11/3/06
1/3/07
14
2. VaR-methods

1.
2. 3. 4.
Well-behaving correlation Nonlinear function Perfect correlation & outlier Zero correlation & outlier All four have the same mean, standard deviation and correlation.
Source: http://en.wikipedia.org/wiki/Correlation_and_dependence
15
2. VaR-methods

Open questions Length of time period for the VCV calculation? If the time span is short, results are volatile, if long, changes are not picked up Period of time chosen? Is the period representative? Will it be different now? Factors or individual instruments? By using factors, one could pay more attention in making sure they are wellbehaved and representative of the issues but this could also backfire Classic case GBP/DEM in 1992, before devaluation should you use forward or spot rates in risk calculations, does history have any value empirically? VCV can be calculated in real time
16
2. VaR-methods
Non-parametric: Historical simulation
Well take four years of daily market data, get approximately 4 x 52 x 5 = 1000 data points for the value of the position Transparent like no other, least amount of assumptions except that tomorrow will be like yesterday No assumptions of normal distribution or stabil VCV-matrix Still one has to decide how long and what period to use Does not solve the problem of instruments that have not been (i.e. new futures and option series) With modern computing results in real time.
17
2. VaR-methods
Non-parametric: Monte Carlo

Decide how many times paths are iterated (N) Create market models for all instruments (or factors) and simulate an imaginary daily price changes Calculate change in portfolios value, given the simulated prices Repeat N times End result is N number of portfolio values, where one can easily locate the 1% VaR figure. MC is only as good as the market model If VCV cannot be used because of lack of historical data or because of heavy non-normality or existence of options in the portfolio, MC is the only way to go. MC is like the historical simulation, but with made-up data Computationally the heaviest, in practice not available in realtime
1. 2.
3. 4.
18
3. VaR-model: creation
Common to all
Whatever method you use, the same grunt work has to be done: Identification and classification of historical price changes or factors, estimating the parameters of their joint distribution Defining the position to be measured and pricing it Getting the VaR metrics out by combining the two
19
Position mapping
Position mapping is critical but often thought to be a secondary issue Should one include whole firm, risk management or only trading positions? Should they be calculated separately or combined? What is position? Long-term financing costs, credit risks, operative risks? How to include nonlinear instruments and other exoticity? When to calculate VaR? A daily figure calculated at the end of the day? How about intraday positions and intraday risks for longer positions?
20
Historical inference
Factors or instruments? Length and choice of data period, possible weighting scheme to give greater weight to recent data over older data VCV-matrix calculated from historical, implied or econometric models? How to accommodate the weak predictability of covariance estimates confidence intervals, statistical significance, seasonal models? Can the system handle non-normal distributions or nonlinearity and should this be accommodated for when planning the data collection?
21
Testing
Naturally VaR-model should be tested before implementation The only practical way of testing is historical simulation VaR could be teached with older data, then checked how it works with out-of-sample period (e.g. how often the 1% threshold is trespassed)
Basle-standard 250 days:

Zone Green Yellow Violations 04 5 Scaling factor 3.00 3.40
Yellow
Yellow Yellow Yellow
6
7 8 9
3.50
3.65 3.75 3.85
Red
10+
4.00
22
4. VaR-metrics and their use
Var-metrics
VaR: max loss usually Conditional VaR (Expected Tail Loss, Expected Shortfall): when losses go beyond VaRlimit, how much they are on average Minimizing CVaR also minimizes VaR
23
Var-metrics
Profit/VaR (vs. Sharpe Ratios Proft/Standard Deviation) Marginal VaR: if you add 1 to one portfolio component, how much your VaR changes Incremental VaR: The change in VaR from adding a position to the portfolio Component VaR: The change in VaR from removing a position from the portfolio PaR Profit-at-risk Relative VaR
Cash Flow at Risk

EBITDA at Risk Long Term VaR Short Term VaR Trading VaR/trading Stop loss x VaR Counterparty VaR
24
Use of VaR-metrics
In practice a well-modeled VaR figure at 99% level means that in a normal year losses larger than the VaR figure are met on average 2.5 times. The higher the probability figure, the smaller the tail section that is under examination. The further one goes down the tail, the less experience (and data) there is, and one should be less confident in the resulting loss estimates. Rule of thumb: the VaR-period (e.g. 1 or 10 days) should be selected so that usually there are no major changes in the portfolio during that time. There is no meaningful way of calculating a daily VaR for a high-frequency operation With a selection of a longer VaR-period, one ends up with less data
25
5. Advanced models
Cornish-Fisher
On slide 4 we noticed that the assumption of normality leads to too low VaR estimates z(cf) = z(c) +1/6 * {z(c)^2 - 1}*S + 1/24 * {z(c)^3 - 3*z(c)}*K - 1/36 * { 2*z(c)^3 - 5*z(c)) * S^2 where z(cf) is Cornish-Fisher critical value z(c) is the critical value for the probability 1-a assuming normality (-2.33 99%) S is skewness and K is kurtosis eli hntien paksuus Now for the 99% case we get a higher z-value (-5.6, -2.33), and VaR estimate would be instead of 2.33 x 1.28% (=2.98%) this: 5.6 x 1.28% (=7.18%).
26
5. Advanced models
Cornish Fisher and the old example

Historical method what would have happened
500
450
Daily VaR CF 99% = -7,18% Daily VaR CF 95% = -2,23%
Variance method: Mean zero, standard deviation 1.28% so 1% worst day would be -2.32635 * 1.28% = -2.98% ..and comparable 5% worst day
400
350
300
250
200
p5%: -1,96%
150
-1.64485 x 1.28% = -2.1%

p1%: -4,65
100
50
Difference? skew -1.37, kurtosis 12.7

-2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%
0 -7.00% -6.00% -5.00% -4.00% -3.00%
27
5. Advanced models
28
5. Advanced models
After Cornish-Fisher
Cornish-Fisher allows working with non-normal distributions as long as there are no other hidden surprises besides non-normal kurtosis and skewness. How to include options and other non-linear instruments? Quadratic (or Delta-Gamma) VaR Beyond the scope of this presentation
29
6. Stress tests and scenario analysis
Scenario analysis
Weaknesses of VaR are well-known, also by the regularors. Even a weak VaR-model can measure risks reasonably enough in a normal environment, but what if something strange happens? Scenario analysis is a close relative to historical analysis. One selects a bad historical event and sees how the portfolio and the VaR measure would have worked. 1987 stock market crash 1992- ERM crisis 1997 Asian crisis 1998 Russian crisis, LTCM 2000 tech bubble 2006 Amaranth implosion 2006 carbon credit collapse 2008 Lehman moment 2010 Euro crisis
30
6. Stress tests and scenario analysis
Stress tests
Stress test is a self-made scenario analysis Anything, not only price changes, can be included in the stress test (e.g. liquidity desert, making opening or closing of positions impossible or very expensive) Correlations moving to -1 or +1 Increases in volatility Changes in forward curves Most famous stress tests recently have been the infamous European bank tests (that did no even include the possibility of a sovereign failure)
31
7. Finally
Development develops
Active portfolio management
Pricing Allocate reserves and capital
RAROC, Risk-Adjusted Return on Capital
Testing (stress and scenario)

Measure (e.g. marketVaR, creditVaR, operative VaR) and control
Risk analysis
Recognize & Avoid
Trading limits
32
7. Finally
Lots of resources at play
In 2006 energy industry used $4.4 billion on portfolio- and risk management systems In 2007 an estimated $5.25 billion were used (thank you, Amaranth!) (Carbon360 survey) One third of hedge funds make their risk management work on Excel perhaps because they know that fancier stuff isnt more effective, or because they want to show what they show to investors Nordic SPAN uses VaR-based calculations for margin requirements All the big participants use VaR, for internal and regulatory purposes Large players (hedge funds) demand and get VaR-based margin practices from their prime brokers
33
7. Finally
Greatest challenges
1.
2.
3.
4.
5.
Conglomerate or departmental risk management bottom-up or top-down Official vs. internal-only Interpreting the greeks, using and calculating volatility- and distribution forecasts Market risk Length of sample, estimating the variance-covariance matrix, non-normality Credit risk using credit derivatives Liquidity risk Still badly known, usually integrated to market risk
34
7. Finally
Greatest challenges
6. Operative risk - law, pricing- and model risks, roque dealers and risk managers. No standard practice, view or certainty 7. Nonlinear instruments - Delta-method, delta-gamma-method, full revaluation (Monte Carlo) 8. Estimating volatilities Volatility of volatility? Historical, implied, econometric? Volatility curve and smile? 9. Estimating correlations Same problems as with volatility estimations. Correlation derivatives could help. Time synchronization issues in products traded in different time zones
35
7. Finally
Mandatory Joke
Managing director wants to hire someone who can answer the question how much is 2 + 2. Engineers uses a slide ruler and states it is between 3.98 ja 4.02. Mathematician guarantees that she can prove it is 4 after two hours of non-trivial calculations. Physicist, by means of deduction, decides the magnitude of the answer is 1x101. Logician, after thinking for hours tells that the problem is solvable. The social welfate professional apologizes his lack of knowledge, but wants to tell it is good that a topic of that importance was brought forward. The lawyer remembers a previous case where it was 4. Trader wants to know before answering are you looking to buy or sell. Risk professional gets up from the chair, checks the aisle so that nobody can hear and whispers to the managers ear: what do you want it to be.
36
7. Finally
On the net
www.gloriamundi.org Largest source for VaR www.rhoworks.com VaR-program for testing www.riskmetrics.com The oldest VaR-producer, the Risk Metrics official manuals, online courses etc are valuable stuff for learners www.riskglossary.com
37
7. Finally
Readings
Jorion, Philippe, Value at Risk: The New Benchmark for Managing Financial Risk 2001 the benchmark book Holton, Glyn A., Value-at-Risk: Theory and Practice 2003 some think this is the best out there (www.value-at-risk.net) Dowd, Kevin, Beyond Value at Risk The New Science of Risk Management 2003 Lots of material, but not that technical. Good for beginners who want to have an overview on the topic Javanainen, Timo, Analytical Delta-Gamma VaR Methods for Portfolios of Electricity Derivatives 2004
38
Thank You!
39

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Value-at-Risk Intro March 2007

2007-2011 Juhani Huopainen (huopainen on gmail)

2007-2011 Juhani Huopainen (huopainen on gmail)

1. What is VaR and what its not

Defining The Risk

2007-2011 Juhani Huopainen (huopainen on gmail)

1. What is VaR and what its not

2007-2011 Juhani Huopainen (huopainen on gmail)

1. What is VaR and what its not

example Q2-07, 1st Mar 2005 26th Jan 2007 (1000)

ENOQ2-07, 1.3.2005 - 26.1.2007

2007-2011 Juhani Huopainen (huopainen on gmail)

1. What is VaR and what its not

example Q2-07, 1st Mar 2005 26th Jan 2007 (1000)

-1.64485 x 1.28% = -2.1%

Difference? skew -1.37, kurtosis 12.7

0 -7.00% -6.00% -5.00% -4.00% -3.00%

2007-2011 Juhani Huopainen (huopainen on gmail)

1. What is VaR and what its not

Already in trouble and only the 7th slide...

2007-2011 Juhani Huopainen (huopainen on gmail)

1. What is VaR and what its not

...but its not that bad

2007-2011 Juhani Huopainen (huopainen on gmail)

2007-2011 Juhani Huopainen (huopainen on gmail)

Three main types

2007-2011 Juhani Huopainen (huopainen on gmail)

Parametric variance-covariance method

2007-2011 Juhani Huopainen (huopainen on gmail)

Parametric variance-covariance method

2007-2011 Juhani Huopainen (huopainen on gmail)

Parametric variance-covariance method

2007-2011 Juhani Huopainen (huopainen on gmail)

10day 90day 180day

2007-2011 Juhani Huopainen (huopainen on gmail)

Parametric variance-covariance method

2007-2011 Juhani Huopainen (huopainen on gmail)

Parametric variance-covariance method

2007-2011 Juhani Huopainen (huopainen on gmail)

Non-parametric: Historical simulation

2007-2011 Juhani Huopainen (huopainen on gmail)

Non-parametric: Monte Carlo

2007-2011 Juhani Huopainen (huopainen on gmail)

2007-2011 Juhani Huopainen (huopainen on gmail)

2007-2011 Juhani Huopainen (huopainen on gmail)

2007-2011 Juhani Huopainen (huopainen on gmail)

Basle-standard 250 days:

2007-2011 Juhani Huopainen (huopainen on gmail)

4. VaR-metrics and their use

2007-2011 Juhani Huopainen (huopainen on gmail)

4. VaR-metrics and their use

Cash Flow at Risk

2007-2011 Juhani Huopainen (huopainen on gmail)

4. VaR-metrics and their use

2007-2011 Juhani Huopainen (huopainen on gmail)

Cornish Fisher and the old example

Daily VaR CF 99% = -7,18% Daily VaR CF 95% = -2,23%

-1.64485 x 1.28% = -2.1%

Difference? skew -1.37, kurtosis 12.7

0 -7.00% -6.00% -5.00% -4.00% -3.00%

2007-2011 Juhani Huopainen (huopainen on gmail)

2007-2011 Juhani Huopainen (huopainen on gmail)

2007-2011 Juhani Huopainen (huopainen on gmail)