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With
)
2
And the estimation % h-day VaR at time t is:
Or the Value at risk of X with confident level :
() *|
+
Finance regulations, like Basel I and Basel II, use VaR deviation measuring the width of
daily loss distribution of a portfolio.
2.1.1. Estimation VaR
2.1.1.1. Normal linear VaR formula: portfolio level
If the portfolio returns are i.i.d and normal distributed with mean and variance
.
We have the estimation formula:
( )
In the h-risk horizon
( )
With
(). This
denition is the basis for the name of conditional value-at-risk. The term conditional
value-at-risk was introduced by Rockefeller and Uryasev.
() ,|
()-
+ For random variables with a possibly discontinuous distribution function
The CVaR of with confidence level - , is the mean of the generalized -tail
distribution:
()
()
With
() {
()
()
,
()
3. Properties of CVaR
o
and
o
VaR
3.1. Properties of CVaR
o
(i) CVaR
o
is translation-equivariant
( ) ( ) CVaR Y c CVaR Y c
o o
+ = +
(ii) CVaR
o
is positively homogenous
( ) ( ) c CVaR Y cCVaR Y
o o
=
If 0 c >
(iii) If Y has a density,
(1 )
( ) (1 ) ( ) ( ) Y CVaR Y CVaR Y
o o
o o
= E
(iv) CVaR
o
is convex in the following sense: For arbitrary (possibly dependent)
random variables
1
Y ,
2
Y and 0 1 < <
1 2 1 2
( (1 ) ) ( ) (1 ) ( ) CVaR Y Y CVaR Y CVaR Y
o o o
+ s +
5
(v) CVaR
o
is monotonic w.r.t. SD(2) (and a fortiori w.r.t. SD(1)),i.ie, if
1 (2) 2 SD
Y Y
then
1 2
( ) ( ) CVaR Y CVaR Y
o o
s
(vi) CVaR
o
is monotonic w.r.t. MD(2), i.e. if
1 (2) 2 MD
Y Y
then
1 2
( ) ( )
alpha
CVaR Y CVaR Y
o
s
Proof: (i) and (ii) are obvious from the definition of ( ) CVaR Y
o
. Let us prove (iii). Since
(1 ) (1 )
( ) ( | ( )
( | ( )
( | ( ))
CVaR Y E Y Y VaR Y
E Y Y VaR Y
E Y Y VaR Y
o o
o
o
= >
= >
= <
Ones see that
(1 )
( ) ( )) (1 ( ))
(
( | ) ( |
) ) (1 ( )
Y Y VaR Y Y VaR
CVaR C
Y Y
Va
Y
Y R Y
o o
o o
o o
o o
= + <
= +
>
E E E
Now we prove (iv). Let
i
a be such that
1
( ] )
1
[
i i i i
C Y VaR Y a a
o
o
+
= +
E
Since [ ] y y a
+
is convex, we have
1 2
1 2 1 2 1 2
1 2 1 1 2 2
1 2
( (1 )
1
(1 Y (1 (1
1
(
)
) [ ) ) ]
)
) [ [
1
(1 Y ]
1 1
( (
]
) ( ) ) 1
Y Y
a a Y a a
a a Y a
CVaR CVaR
CVaR
a
Y Y
o
o o
o
o o
+
+ +
+
+ + + +
+ + +
s
s
+
s
E
E E
(v) and (vi) follow from the fact, that [ ] y y a
+
is monotone and convex.
6
Artzner, Delbaen, Eber and Heath call a risk measure coherent, if it is translation-
invariant, convex, positively homogeneous and monotonic w.r.t.
(1) SD
. One sees that
CVaR
o
3.2. Properties of
o
VaR
(i) VaR
o
is translation-equivariant, i.e.
( ) ( ) VaR Y c VaR Y c
o o
+ = +
(ii) VaR
o
is positively homogeneous, i.e.
( ) ( ) VaR cY cVaR Y
o o
=
If 0 c > .
(iii) ( ) (1 )( ) VaR Y VaR Y
o
o =
(iv) VaR
o
is a monotonic w.r.t. SD(1) i.e. if
1 (1) 2 SD
Y Y
then
1 2
( ) ( ) VaR VaR Y Y
o o
s
(v) VaR
o
is comonotone additive, i.e. if
1
Y and $Y_2$ are comonotone, then
1 2
( ) ( 1) ( 2) VaR Y Y VaR Y VaR Y
o o o
+ = +
Proof. (i)-(v) are nearly obvious. Only (v) has to be proved in detail. If
1
( ) Y f U = with
$U$ uniform [0,1] and f monotonically increasing, then
1 2 1 2
( ) ( ) ( ) ( ) ( ) VaR Y Y f g VaR Y VaR Y
o o o
o o + = + = +
4. Comparison of VaR and CVaR
4.1. VaR
4.1.1. Pros
VaR is a relatively simple risk management notion. Intuition behind -percentile
of a distribution is easily understood and VaR has a clear interpretation: how much you
7
may lose with certain confidence level. VaR is a single number measuring risk, dened
by some specied confidence level, e.g., =0.95. Two distributions can be ranked by
comparing their VaR for the same confidence level. Specifying VaR for all confidence
levels completely denes the distribution. In this sense, VaR is superior to the standard
deviation. Unlike the standard deviation, VaR focuses on a specic part of the
distribution specied by the confidence level. This is what is often needed, which made
VaR popular in risk management, including nance, nuclear, airspace, material science,
and various military applications.
One of important properties of VaR is stability of estimation procedures. Because
VaR
disregards the tail, it is not aected by very high tail losses, which are usually difficult
to measure. VaR is estimated with parametric models; for instance, covariance VaR
based on the normal distribution assumption is very well known in nance, with
simulation models such as historical or Monte Carlo or by using approximations based
on second-order Taylor expansion.
4.1.2. Cons
VaR also has its drawbacks as a risk measure. Some of these are fairly obvious
that VaR estimates can be subject to error, that VaR systems can be subject to model
risk (i.e., the risk of errors arising from inappropriate assumptions on which models are
based) or implementation risk (i.e., the risk of errors arising from the way in which
systems are implemented). However, such problems are common to all risk
measurement systems, and are not unique to VaR.
- VaR Uninformative of Tail Losses
VaR only tells us the most we can lose if a tail event does not occurit tells us
the most we can lose 95% of the time, or whateverbut tells us nothing about what we
can lose in the remaining 5% of occasions. If a tail event (i.e., a loss in excess of VaR)
does occur, we can expect to lose more than the VaR, but the VaR gure itself gives us
no indication of how much that might be.
This can lead to some awkward consequences. A trader or asset manager might
k rm by entering into deals that produce small gains under most
circumstances and the occasional very large loss. If the probability of loss is low enough,
then this position would have a low VaR and so appear to have little risk, and yet the
firm would now be exposed to the danger of a very large loss. A single VaR gure can
also give a misleading impression of relative riskiness: we might have two positions
with equal VaR at some given confidence level and holding period, and yet one position
8
might involve much heavier tail losses than the other. The VaR measure taken on its
own would incorrectly suggest that both positions were equally risky.
Fortunately, we can sometimes ameliorate these problems by using more VaR
information. For example, the trader who spikes his firm might be detected if the VaR of
his position were also estimated at very high confidence levels. A solution to our earlier
problems is, therefore, to look at the curve of VaR against confidence level, and not just
to look at a single VaR gurewhich is in effect to look at the VaR at only one point on
its surface.
4.1.3. VaR Can Create Perverse Incentive Structures
But it is not always feasible to use information about VaR at multiple confidence
levels, and where it is not, the failure of VaR to take account of losses in excess of itself
can create some perverse outcomes. For instance, a rational investor using a VaR risk
measure can easily end up with perverse positions precisely because a VaR-based risk
return analysis fails to take account of the magnitude of losses in excess of VaR. If a
particular investment has a higher expected return at the expense of the possibility of a
higher loss, a VaR-based decision calculus will suggest that we should make that
investment if the higher loss does not affect (i.e., and therefore exceeds) the VaR,
regardless of the size of the higher expected return and regardless of the size of the
higher possible loss. Such a categorical acceptance of any investment that increases
expected returnregardless of the possible loss, provided only that it is insufficiently
probablemakes a mockery of riskreturn analysis, and the investor who makes
decisions in this way is asking for trouble. Admittedly, this example is rather extreme,
because the VaR itself will often rise with the expected return, but the key point is that
we cannot expect a VaR-based rule to give us good riskreturn decisions except in
particular circumstances (i.e., to be precise, unless risks are elliptically distributed or are
rankable by rst-order stochastic dominance, which is a very demanding and
empirically unusual condition.
If an investor working on his/her own behalf can easily end up with perverse
positions, there is even more scope for mischief where decision-making is decentralised
and traders or asset managers are working to VaR-constrained targets or VaR-dened
remuneration packages. After all, traders or asset manage y k firm if
they work to an incentive structure that encourages them to do so. If traders face a
VaR-defined risk target, they will often have an incentive to sell out-of-the-money
ts and hence their bonus; the downside is that the
institution takes a bigger hit once in a while, but it is difficult to design systems that
force traders to care about these bigger hits: the fact that VaR does not take account of
9
bd d centives and encourage traders or managers
VR (d/ VR-defined remuneration package), and promote
their own interests at the expense of the interests of the institutions they are supposed
to be serving.
4.1.4. VaR Can Discourage Diversication
Another drawback is that VaR can discourage diversication, and a nice example
of this effect is provided by Eber et al. (1999). Suppose there are 100 possible future
states of the world, each with the same probability. There are 100 different assets, each
earning reasonable money in 99 states, but suffering a big loss in one state. Each of
these assets loses in a different state, so we are certain that one of them will suffer a
large loss. If we invest in one of these assets only, then our VaR will be negative at, say,
the 95%condence level, because the probability of incurring a loss is 1%. However, if
we diversify our investments and invest in all assets, then we are certain to incur a big
loss. The VaR of the diversied portfolio is therefore much larger than the VaR of the
undiversied one. So, a VaR measure can discourage diversication of risks because it
fails to take into account the magnitude of losses in excess of VaR.
4.1.5. VaR Not Sub-additive
But there is also a deeper problem with VaR. In order to appreciate this problem,
we need rst to introduce the notion of sub-additivity. A risk measure () is said to be
sub-additive if the measured risk of the sum of positions A and B is less than or equal to
the sum of the measured risks of the individual positions considered on their own, i.e.:
( ) () ()
Sub-additivity means that aggregating individual risks does not increase overall risk.
Sub-additivity matters for a number of reasons:
- If risks are sub-additive, then adding risks together would give us an
overestimate of combined risk, and this means that we can use the sum of risks as a
conservative estimate of combined risk. This facilitates decentralised decision-making
within a firm, because a supervisor can always use the sum of the risks of the units
reporting to him as a conservative risk measure. But if risks are not sub-additive, adding
them together gives us an underestimate of combined risks, and this makes the sum of
risks effectively useless as a risk measure. In risk management, we want our
- Risk estimates to be unbiased or biased conservatively.
- If regulators use non-sub-additive risk measures to set capital
requirements, a nancial firm might be tempted to break itself up to reduce its
10
regulatory capital requirements, because the sum of the capital requirements of the
smaller units would be less than the capital requirement of the firm as a whole.
- Non-sub-additive risk measures can also tempt agents trading on an
organised exchange to break up their accounts, with separate accounts for separate
risks, in order to reduce their margin requirements. This could be a matter of serious
concern for the exchange because the margin requirements on the separate accounts
would no longer cover the combined risks.
Sub-additivity is thus a highly desirable property for any risk measure.
Unfortunately, VaR is not generally sub-additive, and can only be made to be sub-
additive if we impose the (usually) implausible assumption that P/L (or returns) is
normally (or slightly more generally, elliptically) distributed.
A good counter-example that demonstrates the non-sub-additivity of VaR is a
portfolio consisting of two short positions in very-out-of-the-money binary options.
Suppose each of our binary options has a 4% probability of a payout (to us) of $100,
and a 96% probability of a payout of zero. The underlying variables (on which the
payouts depend) are independently distributed, so the payout on one binary option is
independent of the payout on the other. If we take the VaR confidence level to be 95%
and the holding period to be equal to the period until the options expire, then each of
our positions has a VaR of 0 at the 95% level. If we combine the two positions, however,
the probability of a zero payout falls to less than 95% and the VaR is positive (and, in
this case, equal to $100). The VaR of the combined position is therefore greater than the
sum of the VaR of the individual positions; and the VaR is not sub-additive (Table).
Table 2.1 Non-sub-additive VaR (Cl: confident level)
(a) Option Positions Considered Separately
Position A
Position B
Payout
Probability Payout Probability
100 0.04 100 0.04
0
0.96 0 0.96
VaRat95%cl
0 VaR at 95% cl 0
(b) Option Positions Combined
Payout
Probability
11
200
100
0
VaRat95%cl
()
100
4.2. CVaR
4.2.1. Pros
CVaR has a clear engineering interpretation. It measures outcomes that hurt the
most. For example, if L is a loss then the constraint
()
.
Dening
t
t
Theorem 1: As a function of o , ( , )
|
o F x is convex and continuously differentiable. The
|
CVaR of the loss associated with any e x X can be determined from the formula
( ) ( , )
| |
o
| o
e
= x minF x (4)
In this formula the set consisting of the values of o for which the minimum is attained,
namely
( ) argmin ( , ) A x F x
| |
o
o
e
= (5)
Is a nonempty closed bounded interval (perhaps reducing to a single point), and the
VaR
|
of the loss is given by
( ) = left endpoint of ( ) x A x
| |
o (6)
In particular, one always has
( ) ( , )
| |
o
o o
e
e x argminF x
.
and ( ( ) , ( )) x F x x
| | |
| o = (7)
The approximation to ( , )
|
o F x is
1
1
1
)
( )
( , [ ( , ) ]
q
k
k
F x f x y
q
|
o o o
|
+
=
= +
(8)
Note that ) ( , F x
|
o is not differentiable w.r.t. o , it can readily be minimized, either by
line search techniques or by representation in terms of an elementary linear
14
programming problem.
Theorem 2
Minimizing the CVaR
|
of the loss associated with x over all e x X is equivalent to
minimizing , ) ( F x
|
o over all ( , ) o e x X , in the sense that
( , )
) ( , ) (
x X x X
mi min x n F x
| |
o
| o
e e
= (9)
Where, moreover, a pair
* *
( , ) o x achieves the second minimum if and only if
*
x achieves
the first minimum and
* *
( )
|
o eA x . In particular, therefore, in circumstances where the
interval
*
) ( A x
|
reduces to a single point (as is typical), the minimization of ( , ) F x o over
* *
produces a pair ( , ) ( ) , X x x o o e not necessarily unique, such that
*
x minimizes the
|
CVaR and
*
alpha gives the corresponding
|
VaR .
Furthermore, ( , )
|
o F x is convex w.r.t. ( , ) o x , and ( )
|
| x is convex w.r.t. x, when ( , ) f x y
is convex w.r.t. x, in which case, if the constraints are such that X is a convex set, the
joint minimization is an instance of convex programming.
5.3. Portfolio Optimization
Decision vector x reprents a portfolio of financial instruments in the sense that
1
,... ) , (
n
x x x = , whith
j
x being the position in instrument j and
1
1 0 1 for , ..., , wit h
n
j
j
j n x x
=
> = =
(10)
j
y : return on instrument j, y random vector of return
1
( ,..., )
n
y x x =
( ) p y : joint distribution density of various returns, continuous w.r.t. y
Lost function:
1 1
( , ) [ ... ]
n n
f x y x y x y x y = + + =
(11)
We compare the minimum CVaR methodology with the minimum variance approach,
and so, to be consistent, we consider the loss in percentage terms
15
The performance function:
1
1 ) ( ) ( , [ ( ) ]
n
y
F x x y p y dy
|
o o | o
+
e
= +
}
(12)
This function is convex and differentiable.
( ) x and ( ) x o : mean and variance f the loss associate with portfolio.
m, V: mean and variance of y, we have:
( ) x x m =
and
2
( ) x x Vx o =
(13)
The optimized portfolio is under the restriction:
( ) x R s (14)
Feasible set of portfolio
{ : sat isfies (11) and (15)} X x x = (15)
The problem of minimizing F
|
over X is therefore one of convex programming.
Recall the approximate function:
1
1
1
( , ) ]
( )
[
q
k
k
x y F x
q
|
o o o
|
+
=
= +
(16)
The minimization of F
|
over X , in order to get an approximate solution to the
minimization of F
|
over X , can in fact be reduced to convex programming. In
terms of auxiliary real variables
k
u for 1, ..., , k r = it is equivalent to minimizing the
linear expression
1
1
1 ( )
q
k
k
u
q
o
|
=
+
subject to the linear constraints (10), (14) and
0
k
u > and 0
k k
u x y o + + >
for 1, ..., k r =
16
the reduction to LP does not depend on y having a special distribution, such as a normal
distribution; it works for nonnormal distributions just well.
In the numerical experiment, we will carry out the Liner Programming to find the
optimized portfolio. We draw 3 sets of data, one from the normal distribution, one has a
skewness, high kurtosis, which is similar to the behavior of market, and finally, we take
data from top 30 stock in Vietnamese market from 6/5/2011 to 2012
And we have the following proposition:
Proposition
3 problems of optimizations:
P1) minimize ( ) x
|
| over x X e
P2) minimize ( ) x
|
o over x X e
P3) minimized
2
( ) x o over x X e
The P3 is the Markowitz (1952) Mean-variance approach.
Suppose that the loss associated with each x is normally distributed, as holds when y is
normally distributed. If 0 5 . | > and the constraint (14) is active at solutions to any two
of the problems (P1), (P2), and (P3), then the solutions to those two problems are the
same; a common portfolio
*
x is optimal by both criteria.
5.4. Numerical result
Practices
Flatform: Windows 7 OS, Matlab version 7.9.0.529
Hardware: RAM 2GB, CPU T7500 Core 2 Duo 2.2 GHz
VaR and CVaR which one is better? As the contents we mention above, CVaR must be better
used in finance(and more specifically in the field of financial risk measurement) because CVaR
dominates over VaR in giving information, properties and sensitivities.
We will use CVaR as our main risk measure and apply it to optimize portfolio with a given
return. To make our purpose objectively we will build efficient frontier of CVaR and expected
return and also build mean-variance efficient frontier.
17
Inputs:
Data include: Stock 1, Stock 2, Stock 4
Time (days) 100
Min Return 0.00011
File NormalDistributed.xlsx (This file contains data which is simulated follow Gaussian
distribution with skewness = 0 and kurtosis = 3).
Function Plot
Outputs:
Time for this Plot is 16.698766 seconds.
Figure 5.1 Efficient frontier of MV and MCVaR approach
The meaning of this figure:
Above figure: one circle is an optimized portfolio. With respect to a given return, we
have its volatility. For a circle we see that volatility of that portfolio and expected return pays
for that volatility. If we want more expected return, we must accept a higher volatility
18
Below figure: one circle is an optimized portfolio. With respect to a given return, we
have its CVaR. In similarity, if we want more expected return, we must to take a higher CVaR.
What we see in this figure is with a given expected return, we have its volatility and in
bad case, we will lost a value of CVaR y percent probability.
There is an interest here. In the Gaussian distributed case the weights of the stocks in mean-
variance, which is optimized, is equal with weights of the stocks in CVaR.
Case 1: Gaussian distribution (skewness = 0, kurtosis = 3)
Inputs:
Data include: Stock 1, Stock 2, Stock 4, Stock 9
Time (days) 1000
Min Return 0.00011
File NormalDistributed.xlsx (This file contains data which is simulated follow Gaussian
distribution with skewness= 0 and kurtosis = 3).
Function Calculate
Outputs:
Time for this calculation is 26.025475 seconds.
Figure 5.2: The result of Gaussian portfolio
Notes:
- As we see, the weights for all stocks in Mean Var seem have the same value with
weights for all stocks in CVaR.
- The Min Return of all stocks in Mean seem have also the same value with Min
Return CVaR.
- These above values are suitable with the theory. In theory, the weights for Mean
Var and CVaR in portfolio will be the same in Gaussian distribution with skewnessis
zero and kurtosis = 3.
19
Case 2: Gaussian distribution (with skewness 0 and kurtosis > 3)
Inputs:
Data include: Stock 1, Stock 2, Stock 3, Stock 5
Time (days) 1000
Min Return 0.00011
File SkewKur.xlsx (This file contains data which is simulated follow Gaussian
distribution with skewness 0 and kurtosis > 3)
Function Calculate
Outputs:
Time for this calculation is 15.163211 seconds.
Figure 5.3: The result of skewness portfolio
Notes:
- As we see, the weights for all stocks in MeanVar seem have the different value with
weights for all stocks in CVaR.
- The Min Return of all stocks in MeanVaRseem have also the different value with
Min Return CVaR.
- These above values are suitable with the theory.
Case 3: VietNam stocks
Inputs:
File 30Stocks.xls (This file contains return of stocks data which is extracted from
VietNamstocks market).
W k db k.
Data include:PVD, KDC, PNJ, FPT.
20
Time (days) 100
Min Return 0.00011
Function Calculate
Outputs:
Time for this calculation is 0.294143 seconds.
Figure 5.4: The histogram of Vietnamese stocks
PVD KDC
PNJ FPT
21
Figure 5.5: The result of Vietnamese stocks
Notes:
- As we see, the weights for all stocks in MeanVar seem to be very different with
weights for all stocks in CVaR.
- The Min Return of all stocks in MeanVaR also seem to be very different with Min
Return CVaR.
- Because the distribution of VietNam stocks return is not good enough.
22
6. Conclusion
The report gives a clear review on VaR and CVaR, their properties, pros and cons.
Although VaR has more popular than CVaR, but CVaR has more brilliant advantage as
a coherent risk measure. The optimization of CVaR is more simple than the complicate
CVaR although recent development. The minimization of CVaR does not give an
optimization of VaR, but it should also be good from the perspectives of (P2). The
numerical show the valid result for the proposition. Linear programming and
nonsmooth optimization algorithms that utilize the special structure of the
minimum CVaR approach can be developed. Additional research needs to be
conducted on various theoretical and numerical aspects of the methodology.
23
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Books:
[1] Carol AlexanderMarket Risk Analysis IV - Value at Risk, John Wiley&Son