# LECTURE NOTES

Mathematical Modeling and its Application in Finance

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Lecture 3: RiskMetrics and Value-at-Risk

Stavros A. Zenios Operations and Information Management Department The Wharton School University of Pennsylvania

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OUTLINE

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**Overview of RiskMetrics Value-at-Risk (VaR) methodologies Monte Carlo simulations
**

• Reading: Bulkpack, items no. 7 and 8. • Further reading: Introduction to RiskMetrics, Morgan Guarantee Trust Company, Fourth edition. RiskMetrics-Technical Document, Morgan Guarantee Trust Company, Fourth edition.

– – – – General descriptionin of the technical document, pp. I-vi, pp. IPart I: Risk Measurement Framework Chapter 6. Market risk methodology Appendix E: Routines to simulate correlated normal random variables, variables,

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I. Overview of RiskMetrics™

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Tools for assessing risk exposure of a position (in global market risks) using VaR (Value-at-Risk) Set of risk measurement methodologies Data sets of volatility and correlation data used in computing market risk • Daily re-estimated • 1-day horizon, 1-month horizon, according to BIS requirements (three data sets) • Each data set contains information on 400 instruments: FX, money markets, bonds, equity indices in 23 countries, commodities

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Value-at-Risk (VaR): There is a probability of x% that the portfolio will suffer a loss greater than VaR during the planning period.

• Typically x is taken to be 1% or 5% • Planning period is 1 -day (for active trading), or 1 -month (for portfolio management), or the 10-day holding period specified in the BIS directives.

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**Uses historical return data to calculate volatilities and correlations
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**I. Overview of RiskMetrics™: Practical use of VaR information
**

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Management information on the risk exposure of trading and investment operations of the institution. Setting limits on positions and resource allocation. Performance assessment: efficiency with which market risk (measured by VaR) is translated to high revenues and low realized volatility of revenues. Regulatory reporting: capital adequacy requirements based on market risk exposure.

• European Union directive (effective January 1996) requires banks and investment firms to set aside capital to cover market risks • Bank of International Settlement:

– allows internal models for measuring market risk but imposes stringent stringent requirements on some of the risk factors. – 10-day risk horizon 10– multiplier of VAR estimate to determine capital adequacy margins

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I. Overview of RiskMetrics: Why is accurate measurement of VaR important?

Underestimating VaR: Regulatory pressures, cost of Federal or Central Bank guarantees etc. n Overestimating VaR: Paying too much for insurance.

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• Example: State of California drivers’ insurance requirements:

– Post $30,000 bond with the State, e.g. earning 5% if not used. – Buy an insurance policy. E.g., Pay $2,500 per year with an actuarial value of $2,000, and actuarial therefore costs $500 per year if not used.

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**ii. Value-at-Risk Methodologies
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Calculate the VaR due to holdings in a financial instrument in RiskMetrics dataset .

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**Map cashflows of target position to RiskMetrics instruments and
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calculate VaR of target position:

• Linear relations? • Nonlinear relations?

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Delta and Delta-Gamma Approximations or Monte Carlo simulations

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Example 1: Single position VaR calculation

USDUSD -based corporation holding DEM 140 million FX position. What is y our VaR over a 1 your 1day horizon at the 5% probability level, I.e., what is the least amount you could loose in the next day with probability less 5%. (Once every 20 days you m ay loose this money!) may Assume FX rate is today 1.40 DEM/USD and daily standard deviatio n of this rate has, deviation historically, been

σ = 0.565%

Assuming normality of standardized returns rate is not expected to drop by more than

rt / σ t

then then the DEM/USD exchange

1.65σ = 0.932%

RiskMetrics provide users with the VaR statistic

, 95% of the time.

Hence, FX risk of our position is $100 million x 0.932% = $932,000. $932,000.

1.65σ .

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Example 2: Two position VaR calculation

USDUSD -based corporation holding DEM 140 million position in 10-year German 10governemnt bonds. What is your VaR over a 1 -day horizon at the 5% probability level, 1I.e., what is the least amount you could loose in the next day w ith probability less 5%. with (Once every 20 days you may loose this money!) Risk exposure: Still USD 100, but exposed to interest rate risk on the bund and FX risk.

σ FX = 0.565%

σ10−b = 0.605%

FX risk= $100 x 1.65 x 0.565% = $932,000 Interest rate risk=$100 x 1.65 x 0.605% = $999,000. Correlation of 10-year German govt bond with DEM/USD exchage rates: 10-

ρFX ,10−b = −0.27

Hence,

VaR =

(.999

2

**+ .9322 + 2 ρ FX ,10 −b × 0.999 × 0.932)
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= $1.168 million.

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**Example 3: VaR calculation on a portfolio of cashflows
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Consider an instrument that gives rise to three USD 100 cashflows each occuring at the end of 1, 4 and 7 months. RiskMetrics provides volatility and correlation estimates of risk -free interest rates at maturities risk1m 3m 6m 1yr 2yr 3yr 5yr 7yr 9yr 10yr 15yr 15yr 15yr 20yr 30yr

RiskMetrices vertices (or RiskMetrics cashflows ) cashflows)

Portfolio

100 1m 100 1m 100 60 3m 60

100 4m 40+70 6m 110

100 7m 30 1yr 30

Cashflow mapping

RiskMetrics cashflow

**rp = .33r1m + .20r3 m + .37r6 m + .10r1 yr
**

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General VaR calculation on a portfolio of cashflows

Portfolio return is a weighted linear combination of RiskMetrics returns:

rp = ∑ wj rj

j =1

M

The VaR of the portfolio is given by

VaR = VQV T

where

**V = (w1 ⋅1.65σ1, w2 ⋅1.65σ 2 ,.....,wM ⋅1.65σ M )
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and Q is the correlation matrix

1 ρ1m, 3m Q= ρ 1m, 6 m ρ1m,1 yr

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ρ 3m,1m 1 ρ 3m, 6 m ρ 3m,1 yr

ρ 6 m,1m ρ 6 m,3m 1 ρ 6 m,1 yr

ρ1 yr ,1m ρ1yr , 3m ρ1 yr , 6m 1

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VaR calculations for nonlinear positions

In Example 1 our position (in FX) varies linearly with the DEM/USD exchange rate. In Example 2 our position varies as a linear comb ination of changes in the 10-year bund and the DEM/USD exchange rate. What to do if position varies varies nonlinearly with changes in the underlying rate. Full valuation Position value Delta+Gamma

Delta 1.40

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DEM/USD 13

Delta and Gamma approximations

∂P ( r ) 1 ∂ P( r ) P( r1 , r ) = r1 + P( r0 ) + ( r − r0 ) + (r − r0 ) 2 ∂r 2 ∂r 2

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**1 2 ∆P = ∆r1 + δ∆r + γ∆r 2
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For a linear approximation (delta approximation):

VaR ( P) = 1.65 (σ + δ σ + 2δσ 1σ r ρ1, r )

2 1 2 2 r

All information is given by RiskMetrics and the delta of the security.

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For a quadratic approximation (delta-gamma): RiskMetrics sigma’s are not quite applicable, since the quadratic term introduces skewness in the distribution. (Negative returns are squared.)

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Monte Carlo simulations

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Scenario generation: Using the RiskMetrics volatility and correlation estimates generate a large number of scenarios for the underlying assets in our portfolio. (First identify the relevant RiskMetrics instruments and do the cashflow mapping if needed). Portfolio valuation: for each scenario calculate the portfolio value. Calculate VaR: Report the distribution of the portfolio returns, or calculate the value that can be lost with a certain probability (VaR).

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**Mapping cashflows onto RiskMetrics vertices
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Split the portfolio cashflows among the nearest RiskMetrics vertices in such a proportion that: Market value is preserved: total market value of the RiskMetrics cashflows equals the market value of the original cashflow Market risk is preserved: total market risk of the RiskMetrics cashflows equals the market risk of the original cashflow Sign is preserved: RiskMetrics cashflows have same sign as original cashflow

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Monte Carlo simulation of correlated normal random variables

Assume a covariance matrix Q of correlated normal random variables. 1. Let Q = P T P 2. Compute a vector of standard normal random variables (e), I.e., the covariance matrix of e is the identity I. 3. Compute

y = PT e

The random vector y has a multivariate normal distribution with covariance matrix Q.

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