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t i t i i

t r
, ,
) ( q o + =
I D D
t t t
~ ~ ~
2 1
c q
) ( ) (
) ), ( ( ) (
,
,
t x
P
S
D t y
t x f t y
l
e
l
e l
l e e l
=
= u
t t
t m
t
t

q
q
q A =
(
(
(

=
,
, 1

=
+ + =
m
i
k i ki k
t t r t x
1
) ( ) ( ) ( c | o
6
6
Risk Modeling Methodologies
Delta Normal
Approximation
Pure Historical
Simulation
Filtered Historical
Simulation
Monte-Carlo
Normal Simulation
Modeling assumptions
Simplified but high
performance approach
Accounting for covariance
dynamics
Improved forward looking
Handling of instrument with
Insufficient historical data
Linearization
Normality assumption
Cross-product dependency
by Covariance
Risk factor compression
No distribution assumption
Easy to understand / often
used
Exact treatment of
derivatives

Modeling assumptions
Modeling assumptions

Modeling assumptions

Future = past
Constant volatility
Constant correlations
Risk factor compression
Dynamic correlation/vola
Non parametric
assumption of residuals
Risk factor compression
Normality assumption
Cross-product dependency
by VCV
No inclusion of fat-tail
Risk factor compression
Accounting for covariance
dynamics
Inclusion of fat-tails
Improved forward looking
Exact treatment of
derivatives
Handling of instrument with
Insufficient historical data
Accounting for covariance
dynamics
Improved forward looking
Exact treatment of
derivatives
Features Features Features Features
1
3
Ensured by:
Volatility filter &
Quantile
correction
1
Ensured by:
Inclusion of
specific risk
2
3
Large-scale
Medium-term
Medium-scale
Short-term
Ensured by:
Analytical
mapping of
instruments
3
2
1
2
2
Improvements

+ |
.
|

\
|


= = =
T
t
m
i
ki i
m
i
i ki k
T t r t x
ki
1 1
2
1 ,
) ( ) (
min
| e |
| o
see Tibshirani, R. J. (1996)

,1

,2

,3
2

( )
2
1
0
,
2
,
1
0
,
) (
1
1

, ) (
1
1

=
J
j
j t i i
j
J
t i
J
j
i
j
J
t i
j t r
j t r

t i t i i
t r
, ,
) ( q o + =
.

) ) 1 ( (

,
,
1 ,
t i
t i i
t i
t r
o

q
+
=
+
t i T i T i
t r
, , ,
) (
~
q o =
1
see Barone-Adesi et al.(1998)

1
1
see Franconi and Herzog (2012)
1
0 500 1000 1500 2000 2500
-0.01
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
Time points
F
r
e
q
u
e
n
c
y

o
f

V
i
o
l
a
t
i
o
n
s
0 500 1000 1500 2000 2500
-0.01
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
Time points
F
r
e
q
u
e
n
c
y

o
f

V
i
o
l
a
t
i
o
n
s
1
Portfolio Aggregation using the Delta Normal Approximation
Risk Factor Data
i t
r
,
r : Return
t : Time
(
(
(

=
m t
t
t
r
r
r
,
1 ,
...
) (
t
r mean =
Client Position
Weights
Instrument Data
Derivatives and
Structured Products

, z k
v

,k t
x

,k e
o
Betas on Risk
Factors |
k,i
, c
k
v : Weights
z : Client portfolio id
x : Instrument returns
k : Instrument no.
o : Delta (first order derivative)
e : Derivative no.
c
k
: Idiosyncratic risk (specific risk)
E
c
: Intrinsic covariance matrix
| : Beta value of k-th instrument
to i-th benchmark/risk factor
E: covariance matrix risk factors
|
k,i
= OLS(x
t,k
, r
t,i
, selection rules)
| = [ |
k,i
] matrix nxm

( )
n
diag c c
c
...
1
= E
Risk
LT
E

, z k
v
i k,
|
c
E
z corrected
T T T
z
VaR
Dv D v v D D v
o o
| | o
c
) (

1
u =
E + E =
(
(
(
(

=
k e
k
D
,
, 1
. 0 0
. ... . 0
0 . ... .
0 0 .
o
o
D
3
3
Portfolio Aggregation using scenarios
Risk Factor Data
i t
r
,
r : Return
t : Time
(
(
(

=
m t
t
t
r
r
r
,
1 ,
...
) (
t
r mean =
Client Position
Weights
Instrument Data
Derivatives and
Structured Products

, z k
v

,k t
x

,k e
f
Betas on Risk
Factors |
k,i
, c
k
v : Weights
z : Client portfolio id
x : Instrument returns
k : Instrument no.
f : derivative fomula
e : Derivative no.
c
k
: Idiosyncratic risk (specific risk)
: scenarios of the risk factors
| : Beta value of k-th instrument
to i-th benchmark/risk factor
: scenarios of the idiosyncratic risk
|
k,i
= OLS(x
t,k
, r
t,i
, selection rules)
| = [ |
k,i
] matrix nxm

Risk
) (
~
,
s r
T k

, z k
v
i k,
|
c
~
)) (
~
( ) ) (
~
(
) (
~
) (
~
) (
~
) (
~
) (
~
2
1
2
1
1 1 1
s r quantile VaR s r
s s r f v s s r v s r
port Z port
S
s
z
l i
m
i
li e
E
e
e
K
k
k i
m
i
ki k port
corrected
o
o
c | c |
= =
|
.
|

\
|
+

+ |
.
|

\
|
+ =


=
=
= = =
e
f
3
3
) (
~
,
s r
T k
) (
~
s
k
c
-0.6
-0.4
-0.2
0
0.2
0.4
-0.6 -0.4 -0.2 0 0.2
A
n
a
l
y
t
i
c
a
l

B
e
t
a
s

(
P
C
1
)

Regressed Betas (PC1)
-0.4
-0.2
0
0.2
-0.4 -0.2 0 0.2 0.4
A
n
a
l
y
t
i
c
a
l

B
e
t
a
s

(
P
C
2
)

Regressed Betas (PC2)
-1
-0.5
0
0.5
1
-0.6 -0.4 -0.2 0 0.2 0.4
A
n
a
l
y
t
i
c
a
l

B
e
t
a
s

(
P
C
3
)

Regressed Betas (PC3)

2
1
) ( ) ( ) ( t t t r
j j
c o + =
2
3
In order to improve the forward-looking properties of the
model
A volatility filtering procedure is applied
A weighing factor is used in the computation of historical
volatilities (EWMA) or a GARCH type model
23
96 . 0 =
95 . 0 =
94 . 0 =
9 . 0 =
99.5% 99% 95% 90%
99.87% 99.62% 96.55% 91.86%
99.78% 99.43% 96.02% 91.24%
99.73% 99.35% 95.81% 90.93%
99.68% 99.27% 95.61% 90.74%

Problem: While forward-looking properties are ensured, there


is still uncertainty in tail estimation
Solution: Use weighing factor and quantile correction
Original quantile (before correction)
However: leads to the usage of a smaller effective
number of historical data used in the computation of the
volatilities
To mitigate this effect a quantile correction is calculated
based on a look-up table
Depending on the value of a higher quantile is computed
than was originally aimed at.
The difference to the original quantile (before correction) is
the quantile correction add-on
C
o
r
r
e
c
t
e
d

q
u
a
n
t
i
l
e

R
e
t
u
r
n
s

Scenario
Scenario
Volatility
filtering
Instrument returns
before volatility filtering
Instrument residuals
after volatility filtering
Positions show
instabilities in volatilities
Positions show
stationary behavior (no
instabilities, thus good
forecastability)