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A new approach to component VaR

R. B. Carroll, T. Perry, H. Yang, A. Ho


Royal Bank of Canada, Group Risk Management Trading & Insurance, 200 Bay Street,
15th floor, South Tower, Royal Bank Plaza, Toronto, Ontario, Canada M5J 2J5
This paper presents a new probabilistic denition of component value-at-risk (VaR). It is
shown that, for well-behaved return distributions, this denition is equivalent to the
standard denition of component VaR. However, this new approach is convenient
because it has a graphical interpretation and facilitates rigorous analysis. Furthermore,
it leads naturally to component VaR estimators for both parametric and scenario-based
risk management systems. These estimators are applied to a sample portfolio and
present a simulation to recommend which estimator should be used in practice.
1. INTRODUCTION
Value-at-risk (VaR) has become an indispensable tool for daily risk manage-
ment at nancial institutions (see Jorion 2000; JP Morgan 1996). Its eective-
ness stems from its ability to aggregate risk across products and portfolios.
However, proactive risk management requires a more comprehensive risk
analysis. This has led to the introduction of three closely related VaR tools:
component VaR (CVaR), incremental VaR (IVaR), and marginal VaR (MVaR).
In layman's terms, marginal VaR is the change in VaR resulting from adding $1
of exposure to a position. Incremental VaR is the change in VaR due to adding
a new position of any specied size. Thus marginal VaR is a good measure of
sensitivity to small position changes, whereas incremental VaR accounts for
nonlinearities that may be signicant for large position changes.
This paper focuses on the analysis and calculation of CVaR, which measures
the contribution that an arbitrary subportfolio makes to the aggregate VaR. In
other words, component VaR provides a decomposition of risk that accounts
for diversication. CVaR is a complement to VaR that provides insight into
hedging and estimates the impact of changes to portfolio positions. However, an
ecient means of calculating CVaR is well known only for parametric VaR
systems that assume that returns are normally distributed (see Garman 1996,
1997). This leaves an important void for value-at-risk systems that use Monte
Carlo, historical simulation, or a parametric approach with nonnormal return
distributions. Thus, the key contribution of this paper is that it provides a
practical means to estimate CVaR for all value-at-risk systems. The secondary
goal of this work is to provide a general framework that facilitates both
theoretical and practical analysis of component VaR. This will conveniently
allow researchers and practitioners to study the properties of CVaR and to
develop new estimators that are tailored to their specic purposes. Interested
57
readers should also refer to the paper by Hallerbach (1999), which independ-
ently took a similar approach to developing general CVaR estimators.
In Section 2 we formulate a mathematically precise denition of CVaR. This
will provide the framework for further analysis, which we will pursue in
Section 3. Section 4 investigates the practical estimation of CVaR. We will see
that the new denition provided in Section 2 leads naturally to both parametric
and scenario-based estimators. In addition, we apply these CVaR estimators to a
sample nonlinear portfolio. This section also contains a simulation experiment
and discussion that investigate the behavior of these estimators.
2. A FORMAL DEFINITION OF CVAR
Suppose that we are given two portfolios, T and o. Normally we expect that o is a
subportfolio of T, but this need not be the case. Let S and P be random variables
that model the prot and loss (P&L) of portfolios o and T, respectively. The
component VaR of S, denoted CVaR(S), is the expected contribution of S to the
VaR of P. More precisely,
CVaR(S) = E[S [ P = VaR(P)]. (1)
where VaR(P) satises Pr

P - VaR(P)

= o for some given condence level o.


In other words, the component VaR of S indicates the expected P&L of portfolio
o in the event that P realizes its VaR. Note that this denition and the discussion
that follows is general enough that there is no need to explicitly set the condence
level associated with VaR. Also note that the conditioning is on negative VaR(P)
because VaR is normally expressed in terms of loss. Refer to the Appendix to see
that this denition is equivalent to the JP Morgan denition of incremental VaR
1
(see Laubsch 1999) for suciently smooth random variables.
3. ANALYSIS OF CVAR
This section uses denition (1) as the basis for analysis that provides a rigorous
understanding of component VaR as well as practical formulas for its calcula-
tion. The following theorem expresses CVaR in terms of convenient statistics.
Theorem 1 Suppose P and S are bivariate elliptically distributed.
2
Component
VaR can be expressed as
CVaR(S) =
COV
S.P
o
2
p
VaR(P) E[S]
COV
S.P
o
2
p
E[P]. (2)
where COV
S.P
denotes the covariance between S and P, and o
2
p
denotes the
variance of P.
1
Although JP Morgan introduced the term incremental VaR for this quantity, the term component
VaR has become industry convention.
2
The observation that this assumption is sucient should be credited to Hallerbach (1999).
Journal of Risk
R. B. Carroll et al. 58
Proof. S has a least-squares decomposition S = kP P
J
, where k = COV
S.P
,o
2
p
.
It follows from this decomposition that P and P
J
are uncorrelated. It is clear that
uncorrelated bivariate Gaussian random variables must be independent. Kelker
(1970) generalized this result to bivariate elliptic random variables. Thus, P and
P
J
are independent. Substitute the least-squares decomposition into denition
(1) to obtain CVaR(S) = kVaR(P) E[P
J
[ P = VaR(P)]. Since P and P
J
are independent, CVaR(S) = kVaR(P) E[P
J
] (see Doob 1990). Finally,
substitute P
J
= S kP. &
This result relied on the bivariate elliptic distribution assumption in order to
obtain the linearity of the conditional mean. In intuitive terms, the error in
applying this theorem to nonelliptic distributions will depend on just ``how
much'' dependence the random variables can exhibit while maintaining zero
correlation. Of course, applying this theorem to portfolios with returns that are
not reasonably approximated by elliptic distributions, such as portfolios with
very short term at-the-money options, could be dangerous. The example in
Section 4 will give some comfort in applying the theorem to portfolios contain-
ing options. The following simplication of the theorem is immediate.
Corollary 1 If, in addition to the assumptions of Theorem 1, P and S have
zero mean, then
CVaR(S) =
COV
S.P
o
2
p
VaR(P). (3)
An additional assumption of normality lets us express the component VaR in
terms of VaR(S) rather than VaR(P). Corollary 2 may be particularly useful
since the normality assumption is consistent with the standard parametric VaR
methodology (see JP Morgan 1996). Note that it gives a geometric interpreta-
tion of component VaR in terms of the projection of VaR(S) onto VaR(P). The
result is consistent with Jorion (2000).
Corollary 2 If P and S are normally distributed with zero mean, then
CVaR(S) = ,
S.P
VaR(S). (4)
where ,
S.P
is the coecient of correlation between S and P.
Proof. The result follows immediately from the fact that VaR(P) = co
p
and
VaR(S) = co
S
, where c is the z-score corresponding to a given condence
interval for a standard normal distribution. &
4. ESTIMATION OF CVAR
There are three methods that a risk management system can use to compute
VaRparametric, historical scenarios, or Monte Carlo scenarios (see Jorion
1996; Laubsch 1999). This section demonstrates the practical calculation of CVaR
for each of these implementations. The formulas discussed in Section 3 can be
Volume 3/Number 3, Spring 2001
A new approach to component VaR 59
used to estimate CVaR whenever the proper statistics (VaR, covariance, and
variance) are available, regardless of the VaR methodology. Since this approach
relies on statistical parameters, we will refer to it as the parametric CVaRestimate.
Another estimator can be devised for risk management systems that use a
scenario-based methodology (historical or Monte Carlo). Referring back to the
denition from equation (1), it is clear that we can estimate CVaR by computing
the subportfolio P&L under the VaR scenario. Table 1 summarizes the applic-
ability of these two CVaR estimators to the various VaR methodologies.
4.0.1 A simple example As an example, we will calculate the CVaR of
subportfolios o
1
and o
2
dened in Table 2 with respect to the total portfolio
T, also dened in Table 2. The portfolios contain options and shares of IBM as
TABLE 1. Methodologies for computing VaR and
component VaR.
VaR method Applicable
CVaR method
Parametric Parametric
Historical Parametric
Scenario
Monte Carlo Parametric
Scenario
TABLE 2. Portfolio T and subportfolios (22 October 1999).
Portfolio T
Units Security Description
50 S&P500 baskets $1301.65/basket
85 IBM shares $107.135/share
85 IBM puts At-the-money;
58 days until expiry;
volatility at 26.43%
Subportfolio o
1
Units Security Description
85 IBM shares $107.135/share
85 IBM puts At-the-money;
58 days until expiry;
volatility at 26.43%
Subportfolio o
2
Units Security Description
50 S&P500 baskets $1301.65/basket
Journal of Risk
R. B. Carroll et al. 60
well as S&P 500 baskets. Since the VaR is computed over 1 day while the options
mature in 2 months, the returns should be nearly linear with respect to the
underlying. Thus the distribution of returns should be approximated well by
elliptic distributions. Subportfolio o
1
consists of only the options and shares of
IBM, while subportfolio o
2
contains the remaining baskets. P&L vectors for these
portfolios were obtained by repricing them over 500 historical scenarios. These
scenarios were obtained from market data over the past 2 years. The P&L
statistics for both of these portfolios are summarized in Table 3. Since we chose
the 99% condence level, the sixth largest loss among the 500 P&L values
estimates VaR. For portfolio T, this loss occurred using the 09-Jan-98 scenario.
This means that we can use the P&L for subportfolio o under the 09-Jan-98
scenario as an estimate of CVaR. Note that, in this example, the VaR scenario is
the same for both T and o
2
, which can be interpreted as implying that, at the 99%
condence level, the risk of the overall portfolio is driven by the risk in
subportfolio o
2
. In this special case, the scenario estimates of both VaR(o
2
)
and CVaR(o
2
) are equal. Alternatively, we can use the formulas from Section 2 to
produce a parametric estimate of CVaR. Both CVaR estimators are compared in
Table 4.
4.0.2 A numerical experiment As noted above, scenario-based VaR methodol-
ogies facilitate both parametric and scenario-type estimators. The goals of this
section are
1. to provide some guidance on which estimator to use in practice; and
2. to develop a qualitative understanding of the behavior of the estimators.
TABLE 3. Daily P&L statistics generated by a data set of 500 historical scenarios. VaR is
calculated at the 99% confidence level. The VaR scenario is the scenario that generated
the sixth-largest loss.
Portfolio Mean Std. Dev. VaR 99% VaR scenario Scenario description
T 63.24 763.33 1806.00 09-Jan-98 S&P 500 down 3.2%
o
1
15.65 133.27 401.03 21-Apr-98 IBM up 6.13%
o
2
78.89 841.85 2011.23 09-Jan-98 S&P 500 down 3.2%
cov(T. o
1
) 54142
cov(T. o
2
) 63681
TABLE 4 Component VaR estimates. The scenario CVaR is obtained by evaluating the
subportfolios under the 09-Jan-98 historical scenario.
Portfolio Parametric CVaR
calculation
Parametric
CVAR
Scenario
CVAR
o
1
54142
763.33
2
(1806.00 63.24) 15.65 158.04 205.24
o
2
63681
763.33
2
(1806.00 63.24) 78.89 1964.04 2011.23
T 1806.00 1806.00
Volume 3/Number 3, Spring 2001
A new approach to component VaR 61
We expect the parametric estimator to perform well when the assumptions of
Section 3 are met. To test this hypothesis we conducted the following experiment.
Step 1: Generate random P&L vectors We generated 2000 samples of correlated
standard Gaussian random vectors p and s with 500 elements each. Each pair of
sample vectors is meant to model the P&L of a portfolio and a subportfolio.
Step 2: Calculate estimators For every pair of sample vectors, we calculated
both parametric and scenario estimators. The precise formulas are developed as
follows. Let [ p. 6] denote the index of the sixth smallest element of vector p. For
each sample, we calculated the parametric estimator based on equation (2),

s
i
p
i

p
2
i
( p
[ p.6]

1
500

p
i
)
1
500

s
i
. (5)
and the scenario-type estimator based on equation (1),
s
[ p.6]
. (6)
Of course, we can use standard statistical techniques such as the maximum-
likelihood method (see Kay 1993) to generate other parametric estimators if we
are willing to make use of the a priori knowledge that the random variables are
Gaussian. However, for this exercise we wish to take a very general approach.
Step 3: Analyse the results Finally, we calculated the standard error of the 2000
estimates given by equations (5) and (6). This procedure was repeated using
correlations 0, .05, .10, .15, . . . , 1. Figure 1 plots the standard error of the two
estimators against the correlation of p and s. It is clear that the two estimators
exhibit markedly dierent behavior. The following observations are evident.
+ Performance of the scenario-type estimator improves signicantly as correlation
increases.
We will provide some intuition for this behavior by rigorously examining the
endpoints. When P provides no information about S, the correlation is 0 and
s
[ p.6]
is simply a random sample of S. In this case, we expect s
[ p.6]
to have the
same variance as S itself. This explains why the standard error in Figure 1 is very
nearly 1 when , = 0. On the other hand, when P provides complete information
on S, the correlation is 1 and s
[ p.6]
= s
[ s.6]
. Since this is an estimator of VaR(S),
we know from elementary sampling theory (see Lehmann 1998) that this
estimator is approximated by a normal distribution whose variance decays in
proportion to 1,N. For a normal distribution at 99% condence, the propor-
tionality constant is 13.94. This leads us to expect the simulation experiment to
exhibit a standard error of approximately
_
(13.94
1
500
) = 0.17, which is very
close to the realized standard error of 0.13. With this explanation of the two
extreme cases, it is natural to expect a standard error somewhere between these
extremes when P provides partial information about S. This is exactly what
Figure 1 demonstrates.
Journal of Risk
R. B. Carroll et al. 62
+ Performance of the parametric estimator has a parabolic shape; as correlations
increase it initially improves, but eventually deteriorates.
Equation (5) can be interpreted as a regression evaluated at an estimate of
VaR(P). Thus we can think of the error as arising from both the regression
equation and from the point at which the regression equation is evaluated.
Regression theory (see Weisberg 1985) tells us that the standard error of a
regression decreases as correlations increase. Thus, when the correlation is very
high, error from the regression equation is very low. However, the coecient of
VaR(P) will be large and so equation (5) will be sensitive to errors in the
estimate of VaR(P). When correlation is very low, the regression will be a poor
t, but it will not be sensitive to errors in VaR(P). The performance observed in
Figure 2 shows the interplay between these conicting error sources. The
optimal correlation is approximately 0.225.
+ The parametric estimator has substantially less variance than the scenario
estimator, especially when the correlation is low.
Since the performance of the parametric estimator is far superior, we expect
similar behavior even when the distributions are only approximately Gaussian.
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0
0.2
0.4
0.6
0.8
1
1.2
FIGURE 1. Standard error vs. correlation for scenario (top) and parametric (bottom)
estimators. For every given correlation, 2000 samples were generated containing
500 elements each.
Volume 3/Number 3, Spring 2001
A new approach to component VaR 63
5. SUMMARY
The following paragraphs summarize the fourfold contribution of this paper.
5.0.1 Denition of CVaR. The new denition in equation (1) provides an
elegant framework for practical and theoretical analysis of component VaR.
5.0.2 Analysis of CVaR. Section 3 expresses CVaR in terms of familiar statistics.
In particular, Theorem 1 is a convenient expression of CVaR that makes very
general assumptions about the underlying distributions.
5.0.3 Estimators for CVaR. We used equation (1) to derive the familiar
scenario-type CVaR estimator that can be used with historical or Monte Carlo
VaR methodologies. We also explained how to use the equations from Section 3
to devise new estimators, which we referred to as ``parametric estimators'', that
can be used with any risk management methodology.
5.0.4 Practical implementation. Among the two approaches for CVaR estima-
tion applicable to scenario-based VaR implementations, the simulation in
Section 4 provides a strong argument for using a parametric estimator for
approximately normal P&L distributions. We also provided an explanation for
the observed behavior of the estimators.
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0.09
0.095
0.1
0.105
0.11
0.115
0.12
0.125
0.13
0.135
0.14
FIGURE 2. Standard error for the parametric estimator. For every given correlation,
2000 samples were generated containing 500 elements each.
Journal of Risk
R. B. Carroll et al. 64
APPENDIX
The following theorem shows that the denition of component VaR above is
consistent with the JP Morgan denition of incrmental VaR (see Laubsch 1999).
This result is stated, but not proved, by Hallerbach (1999).
Theorem 2 Let s be the market value of portfolio o and let D be the P&L of a
$1 investment in portfolio o, so that S = sD. If both CVaR(S) and (o,os)VaR(P)
exist, then
CVaR(S) = s
o
os
VaR(P). (7)
It is tempting to approach this result by calculating
s
o
os
VaR(P) = s
o
os
{sE[D [ P = VaR(P)] E[P S [ P = VaR(P)]]
= sE[D [ P = VaR(P)]
= E[S [ P = VaR(P)]
= CVaR(S).
Unfortunately, this approach overlooks the subtlety that the expectation terms
are functions of s since they are conditioned on a function of s. Hence the
derivative may not be so simple. Instead, we will approach the theorem from its
foundations. It is rst necessary to dene precisely what we mean by expectation
conditioned on a point. Denote the probability measure by j. If
lim
c0
1
j(T
c
)

T
c
Xdj = C
for every sequence of sets satisfying j(T
c
) > 0 and lim
c0
T
c
= Y
1
(y), then we
dene E[X [ Y = y] = C. Otherwise, we say that E[X [ Y = y] does not exist.
Proof. Dene three families of sets as follows:
U
c
= {P 6 VaR(P) and P cD > VaR(P cD)].
V
c
= {P > VaR(P) and P cD 6 VaR(P cD)].
W
c
= {P 6 VaR(P) and P cD 6 VaR(P cD)].
From the denition of value-at-risk, we know that
j

P 6 VaR(P)

= j

P cD 6 VaR(P cD)

.
It is evident from the decompositions
j

P 6 VaR(P)

= j(U
c
) j(W
c
)
and
j

P cD 6 VaR(P cD)

= j(V
c
) j(W
c
)
Volume 3/Number 3, Spring 2001
A new approach to component VaR 65
that j(U
c
) = j(V
c
). Suppose that there exists an c
0
such that j(U
c
) = 0 for every
c - c
0
. Dene the sets T
o
= {VaR(P) o 6 P 6 VaR(P)] and observe that
the denition of U
c
gives
D 6
VaR(P) P
c

VaR(P cD) VaR(P)
c
onT
o
. (8)
for all c - c
0
. Integrate equation (8) over T
o
and divide by j(T
o
) to obtain
1
j(T
o
)

T
o
Ddj 6
1
c
1
j(T
o
)

T
o
[VaR(P) P] dj
VaR(P cD) VaR(P)
c
.
Take limits to see that
E[D [ P = VaR(P)] 6
o
os
VaR(P).
Apply an analogous argument using V
c
to show that
E[D [ P = VaR(P)] >
o
os
VaR(P).
Thus we have shown that the theorem holds for this case. Otherwise, assume
without loss of generality that j(U
c
) > 0 for c - c
0
. (If this does not hold, then
we can nd a subsequence for which it does.) Note from the denition of U
c
that
VaR(P cD) VaR(P)
c
6 D on U
c
. (9)
Integrate equation (9) over U
c
and divide by j(U
c
) to see that
VaR(P cD) VaR(P)
c
6
1
j(U
c
)

U
c
Ddj on U
c
.
Take limits to see that

o
os
VaR(P) 6 E[D [ P = VaR(P)].
Just as with the case above, apply an analogous argument using V
c
to show that
o
os
VaR(P) > E[D [ P = VaR(P)]. &
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Volume 3/Number 3, Spring 2001
A new approach to component VaR 67