International Conference on Business, Economics and Management,

Yasar University, Izmir Turkey

ALTERNATIVE RISK MEASURES AND EXTREME VALUE THEORY

IN FINANCE: IMPLEMENTATION ON ISE 100 INDEX

Zehra EKSI
Institute of Applied Mathematics METU
Institute of Applied Mathematics METU 06531 Ankara
Phone: + 903122102973; Fax: + 903122102985
E-mail: <zehra_eksi@yahoo.com>

Irem YILDIRIM
Institute of Applied Mathematics METU
Institute of Applied Mathematics METU 06531 Ankara
Phone: + 903122102973; Fax: + 903122102985
E-mail: <iremy@ada.net.tr >

Kasirga YILDIRAK
Department of Economics, Trakya University
Institute of Applied Mathematics METU
Institute of Applied Mathematics METU 06531 Ankara
Phone: + 903122102973; Fax: + 903122102985
E-mail: kasirga@metu.edu.tr

Key words: Coherent Risk Measures, Market Risk, Extreme Value Theory

1 INTRODUCTION

From early 1990’s financial risk measurement has become an highly popular and dominant concept in
financial markets. When we concentrate on the market risk measurement, the immediate figure that we
encounter is Value at Risk (VaR). Although conceptual origins of VaR go far much earlier, it began
to dominate the market when it was introduced by JP Morgan in 1994. Whilst, most firms kept their
models secret, in October 1994, JP Morgan decided to make its Risk Metrics system available on
internet so outside users could access the model and use it for their risk management purposes. As the
VaR was introduced to the market, software suppliers who had received advanced notice started
promoting compatible software. Timing for the release of this document and software was excellent,
because last few years witnessed declaration of huge financial losses of some reputable firms. A
longer list can be found in Dowd’s book [8], but the following part is taken just to give an idea. In
February 1993 Japan’s Showa Shell Sekiyu oil company declared a USD 1050 MM loss from
speculating on exchange rates. In 1994 the most considerable loss was reported by California’s Orange
County and the list goes on. In 1996 the approval of the limited use of VaR measures for calculating

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bank capital requirements by the Basle Committee, made VaR the most widely used financial risk
measure.
Simultaneously some inconsistencies began to be discovered by the theorists. Some of these theorists
offered modifications and extensions in Value-at-Risk while others were offering alternative ways for
financial risk calculation. The first line of research was started by Artzner, Delbean, Eber and Heath in
1997 under the title ”Thinking Coherently”[4]. The major contribution of these scholars was the
introduction of ”Coherent Risk Measures” in 1999 with the paper having the same title. These papers
introduced the consistency conditions which should be satisfied by a sensible risk measure. Since VaR
is not a coherent risk measure in the given context, new risk measures that are both satisfying these
consistency conditions and as easy to compute as VaR have been formalized. An important example
for a risk measure of this kind is Worst Conditional Expectation (WCE) in [5]. Furthermore,
Conditional Value at Risk (CVaR) introduced by Uryasev and Rockafeller in 1999 [16] and Expected
Shortfall (ES) formalized by Acerbi et. al. in 2000 [1] are other well known examples. Another
important contribution in this area was made by Embrechtes, Kluppelberg and Mikosch. The book
called Modelling Extremal Events for Insurance and Finance (1997) is a cornerstone, since it is a
comprehensive source of the Extreme Value Theory (EVT) and its applications in finance area. Due to
these innovations, EVT became one of the most popular methods for forecasting extreme financial
risk. Bensalah applied the EVT techniques to a series of exchange rates of Canadian/U.S. Dollars in
2000 [6]. Also in 2000 Danielson and Morimoto [7] compared the performance of different techniques
of VaR estimations for Japanese Market and they found that EVT risk forecasting has relatively high
performance among others. A similar study for Turkish Market was made by Gencay , Selçuk and
Ulugülya cı in 2003 [15] and Gencay, Selçuk [13] in 2004. Both papers agreed that the EVT method
should be preferred to others.
In this study, our main aim is to compare the relative performance of ES with other risk measures and
performance of EVT with other risk computation methods for Turkish Stock Market. The paper is
divided into two main parts. In the first part, some theoretical background about risk measures and
EVT will be introduced. Application on real data will be given in the second part. This part consists of
data analysis, methodology and empirical results.

2 THEORETICAL BACKGROUND

For the integrity of the paper firstly both statistical and financial definition of VaR will be given. By
its most widely used definition VaR is the maximum potential change (generally loss) in the value of
a portfolio, given the specifications of normal market conditions, time horizon and level of statistical
confidence , when working on log returns i.e.

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where Xt = return of portfolio at time t and Vt = value of the portfolio at time t.

For example VaR95(X) = -.02 means that with 95% probability loss of the portfolio will not exceed 2%
of your total portfolio value. Another definition of VaR is given in terms of statistical quantiles.
Fundamental definition of quantiles is given below.

Left Quantile: Lower quantile X

Right Quantile: Upper quantile X

Using these definitions:

RiskMetricsTM and many other applications of this method assume that the portfolio returns are
normally distributed. Under continuous distribution assumption, q (X) and q (X) become equal.
However, in general VaR is accused not to reflect the risk of a position accurately. One of the several
examples given to support this claim in [2] is :
Consider a portfolio A (made out of long option positions) that has a value of 1000 Euro with
maximum downside level of 100 Euro and suppose that the worst 5% on the given time
horizon T are all of maximum downside. VaR at 5% would then be 100 Euro. Now consider
another portfolio B again of 1000 Euro which on the other hand invests all in strong short
futures positions that allows for a potential unbounded maximum loss. We could easily choose
B in such a way that its VaR is still 100 Euro on the time horizon T. But in portfolio B the 5%
worst losses ranges from 100 Euro to some arbitrarily high value.
If you consider such a case from an investors or a regulators point of view, this could be disastrous.
Indeed, portfolio B can offer higher returns for the same VaR number. Embrechts emphasized in one
of his speech (Goethenburg, 2001) that:
VaR is to finance what body temperature is to a patient, an indication of bad health but not an
instrument telling us what is wrong and for less a clue on how to get the patient system healthy
again.

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2.1 Risk Measures
2.1.1. Coherent and Convex Measures of Risk: Having noticed deficiencies of Value-at-
Risk, Artzner et. Al. introduced a new concept, Coherent Measures of Risk (CRM) in 1997. In [5] a
risk measure is said to be a coherent if it satisfies:
1. Monotonicity: For all X and Y , if X Y , (X) (Y )
2. Translation Invariance: For all X and for all real numbers ;
(X + ) = (X)-
3. Positive Homogeneity: For all 0 and for all X; ( X) = (X)
4. Subadditivity: For all X, Y; (X + Y) (X) + (Y).
Translation invariance property implies that if you add cash to your portfolio and invest it in a riskless
asset, risk of your portfolio decreases by the same amount that. Moreover, this property ensures that
your risk measure and the loss/profit function are in the same numeraire implying that both are defined
in terms of currency. Subadditivity property is translated as ”merger does not create extra risk”.
Positive homogeneity implies that risk of your portfolio is linearly related to the size of your portfolio.
According to the monotonicity axiom, if a portfolio always has lower returns then another portfolio,
then it has higher risk.
Another related measure of risk is the Convex Risk Measures. This time subadditivity and positive
homogeneity axioms are replaced with the convexity axiom (other two axioms are still valid).
Definition (Convexity): For all X and Y and 0, ( X + (1- ) Y) (X) + (1- ) (Y)
Föllmer [12] claims that this assumption is more realistic. Since assuming linear relation between
position size and risk is rare to be observed. VaR is not a coherent measure of risk. Although it
satisfies other three axioms, it fails to satisfy subadditivity. This can be seen through a widely used
example.
There exists two portfolios one is a short call and the other one is a short put. Their loss
distributions are given as:
A: U-price of the underlying stock (you loose money if stock price exceeds the level U)
B: Price of the underlying stock- L (you loose money if stock price falls below the level L).
Both of the probabilities for loss is .03.
Independently, each portfolio has a VaR value of 0 at = .95. However, when you combine them,
newly constructed portfolio has a VaR number of higher than 0. This means that VaR strongly
discourages diversification. It simply says to an investor to put all his money on a single asset instead
of diversifying risk. This is surely unacceptable when we consider the modern portfolio theory.
At this point it is important to note that in the Risk Metrics context VaR is a CRM because asset
returns are assumed to be normally distributed then;
-1
V aR (X)v = E(X) + (1- ) (X)
-1
Where, (1- ) .05, is inverse standard normal distribution. The variance satisfies the basic

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Yasar University, Izmir Turkey

triangular inequality, (X + Y) (X) + (Y), VaR (X+Y) VaR (X) + VaR (Y). However,
outside the Gaussian Space, VaR fails to satisfy both subadditivity and convexity. These properties are
necessary for portfolio optimization. They are related to the convexity of the risk surface to be
minimized in the space of portfolios. Only if the surface is convex, we will have a unique minimum
apart then local minima and risk minimization process will always pick up a unique well-diversified
optimal solution [1].
2.1.2 Alternative Risk Measures:

One of the drawbacks of Value-at-Risk measure other than not being a CRM is being an answer to the
following misspecified question (for = .95). What is the minimum loss incurred in the 5% worst
cases of our portfolio? By asking this question, we cannot take the values at the left tail, values
exceeding VaR level, into consideration. What happens, if we face an outcome from that 5% area?
Last century witnessed many events such as market crashes, financial scandals, natural disasters, in
which portfolio returns took values in the left of VaR values. Just in last five years Turkey went
through three serious falls in Istanbul Stock Exchange Index. Then we should ask:
What is the expected loss incurred in 5% worst cases of our portfolio?
An immediate answer of this question is Tail Conditional Expectation (TCE):

TCE (X) = -E[X X VaR (X)]

Although the above formula offers an answer to our question, it is not a CRM in general. Therefore, it
does not work for our ultimate goal of global risk minimization. It satisfies subadditivity axiom only in
continuous case. A CRM answering the same question is Worst Conditional Expectation (WCE)
(under the assumption that E(X ) < ).

WCE (X) = -inf{E[X A] : A °A; P[A] > 1- }

WCE depends not only to the distribution of X but also the structure of the underlying probability
space. One has to have full information of the possible states of nature. Obviously this assumption is
not easy to fulfill. Although necessary axioms of coherence are satisfied infimum is not a practical
operator to use. We need both a coherent and user friendly method to calculate financial market risk.

2.1.2.1 Expected Shortfall (ES)

Although above formula looks like a complicated formula, the underlying idea is so easy to

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understand. Let n be the number of observations and {Xi}(i=1;…;n) are realized values for random
variable X. After sorting Xi in ascending order, average the first (1- ) % values. In order to do this,
define the order statistics X1::n ... Xn::n. Then find w = [n ] = max {m m n }, by this we reach an
integer value, estimate the - quantile q (X) = Xw::n Therefore (1- ) % worst observations are X1::n
... Xw::n. Then:

By the same method

It is easy to see that ES satisfies the troublesome subadditivity property. More detailed explanation and
transformation from (2) to (1) can be found in [1].

2.2. Extreme Value Theory

Convulsion in financial markets has been evidence that asset prices can display extreme movements
beyond those captured by the normal distribution. So the risk measurement techniques such as VaR
fail to estimate risk in a correct manner. This happens because of the fact that normal distribution,
which is the main underlying block of nearly all VaR methods, is unable to assign reasonable
probabilities to extreme events. At that point, in the literature, one of the solutions suggested for this
problem is Extreme Value Theory.
Extreme Value Theory (EVT) has a long history. The early of pioneers like Fisher, Tippet and
Gnedenko date back to the late 1920s to the early 1940s, and as early as 1958 Gumbel had produced
his fundamental book on the statistics of extremes. The main theme behind these early contributions
was the need to model the stochastic behavior of extremal events. [10]. Interested reader should
consult [11] for the whole theory and extensive list of the references. Here, a short overview of the
theory of EVT will be given.
Before starting EVT, it is appropriate to mention some properties of the financial data. In particular, it
is by now well known that returns on financial assets typically exhibit higher than normal kurtosis as
expressed by both higher peaks and fatter tails that can be found in normal distribution.

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Figure 1: Fat tailed, leptokurtic financial return data

In (Figure 1), the graph of g(x) can be thought as the graph of the returns of a financial asset. The
figure tells us that the probabilities that normal distribution assigns to extreme events (tail events) is
less than it is required. In other words the tails of the normal distribution are too thin to address the
extreme losses. Assuming normality will lead to systematic underestimation of the riskiness of a
portfolio and increase the chance of having a hit. As an example, according to normal distribution the
probability of the occurrence of 1987 crash was a 10-68 in a bell shaped curve. Similarly, if we go back
to more near history LTCM lost $1.71 trillion in one month. Under a normal distribution, such an
event occurs once every 800 trillion years. Thus, in order to get rid of such kind of problems tails of
the distribution must be modeled. This can be done by using EVT. EVT tells us that:
”One can estimate extreme quantiles and probabilities by fitting model to the empirical
survival function of the set of data using only the extreme event data rather than all the data,
thereby fitting the tail only the tail.”
In financial context, by modeling the tails of the distributions our main aim is to reach more accurate
measures of risk both in the VaR and CRM context.

2.2.1. Methods of Applying EVT

In [10] methods used for applying EVT are categorized in two principal groups:
Block Maxima Group of Models: These are models for the largest observation that are collected from
large samples of identically distributed observations. We record daily or hourly losses and profits from
the trade of a particular instrument. The Block Maxima provides a model that may be appropriate for
the quarterly or annual maximum of such values.
Peaks-Over-Threshold Models: These are models for all large observations that exceed a high
threshold. They are considered to be the most useful methods for practical applications since their
more efficient use of the data on extreme values. In this group there are two style of analysis:
Semi Parametric Models: These models are built around the Hill Estimator and its relatives.
Fully Parametric Models: In this study, for the application part, we will impose Generalized Pareto

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Distribution (GPD) method and skip the theoretical explanations on block maxima model. Therefore,
in the following part we will only mention about the theories of Peaks-Over-Threshold Models.
These models are named as peak over threshold models because of the method they use to acquire data
which is necessary in model estimation. When there are n observations, only the ones exceeding a
threshold level is taken and used. The most problematic part is to choose the threshold level which is
denoted by u. This level is expected to represent the beginning of the extreme events, but in general
this kind of information is not easy to find. There are various ways to estimate this threshold level u.
Detailed explanation of these can be found in [11]. POT models are divided into two categories:
Semi Parametric Model: This model assumes that the tail of the distribution has the form
FX(x) = x- L(x), where L(x) is a slowly varying function. The main aim is to find a better estimate of
the parameter which is known as the tail index. There exist three known methods for this purpose:
1. Hill Estimator
2. Picklands’ Estimator
3. The Deckers’-Einmahl-de-Haan Estimator
For the interested readers, more information about these methods can be found in [10, 11].
Parametric Model: In this model, the problem is clearer in Figure 2, where we consider an (unknown)
distribution function F of a random variable X. We are interested in estimating the distribution
function (Fu) of values of x above a certain threshold u. In the literature the distribution function Fu is
called the conditional excess distribution function.

Figure 2
Theorem 1 (Pickands (1975), Balkema and de Haan (1974)): For a large class of underlying
distribution functions F the conditional excess distribution function Fu(y), when u is large, is well
approximated by;

,where

For the parameters and , we have some domain restrictions such as

Also it is proved in [10] that we have the asymptotic property of Fu such that:

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Yasar University, Izmir Turkey

Where,

is called the shape parameter and is called the scale parameter of the distribution. The shape of
GPD under different shape parameters ( < 0, = 0, > 0) and scaling parameter = 1 is illustrated
in Figure 3. The most relevant case for risk management purposes is where > 0, since in this case
GPD is heavy tailed.
In practice, our priority is to estimate the parameters, to do this firstly we have to choose a sensible
threshold level u. However, there is a dilemma here since choosing u is basically a compromise
between choosing a sufficiently high u so that the asymptotic theorem can be considered as essentially
exact and choosing a sufficiently low u that we have enough material to estimate the parameters.
About this problem many solutions are suggested in [11]. After determining u second task is to
estimate the parameters with an appropriate method.

Figure 3
As we mentioned before, our final aim is to estimate the tail VaR and Expected Shortfall of the
financial data by using EVT. In [10], the formula for TVaR and ES are given as:

Where p is the confidence level, n is the total number of observations, Nu is the number of
observations over threshold level and , are parameters we estimated for the GPD.

3. REAL DATA APPLICATION AND PERFORMANCE COMPARISON

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Main usage of the risk measures given in the previous section is to determine a risk capital level which
would be enough to prevent the position from ending with a high loss in case of significant downside
movement in the market. Since it includes extreme values, a volatile market provides a suitable
environment to compare the relative performance of different risk modeling approaches. As an
emerging market, Turkish stock market is obviously a good candidate with its history of considerable
number of shocks.

3.1.Data and Methodology

The data set is the daily the closing values of ISE-100 index from January 5th 1998 to April 1st 2005.
Data is divided into two parts. The first part is from January 5th 1998 to December 14th 2004 and used
as historical data for parameter estimation. The rest of the data is used to test the validity of the
models. Logarithmic returns are used. All computations are done in MATLAB. The relative
performance of Bootstrap, Historical Simulation method, Monte Carlo Simulation method, Variance-
Covariance approach -under both normal and student’s-t distribution-, GARCH, t-GARCH and EVT
technique - with using Generalized Pareto Distribution- are compared in terms of TailVaR and
Expected Shortfall basis. GARCH methods and GPD application necessitates the analysis on the
appropriateness of data. GPD is applied in three steps:

1. Data analysis
2. Determination of threshold level
3. Parameter estimation and TailVaR, ES computations

Data Analysis: Firstly, in order to get an idea about the distribution of the historical data, kurtosis is
calculated. A kurtosis higher than 4 indicates a deviation from the normal distribution. Higher the
kurtosis is, higher the peak of density and higher the tails of the distribution are. But only checking
kurtosis is not sufficient to conclude that the data set is heavy tailed. Moreover, it has to be
investigated graphically. This investigation is done through QQ-plots of the data set versus Normal
and Generalized Pareto Distributions. If the parametric model fits the data well, these graphs must
have linear form. Thus the graph makes it possible to compare various estimated models and choose
the best. The more linear the QQ-plot is, the more appropriate the model is, in terms of goodness of fit.
Moreover, QQ-plot makes it possible to determine how well the selected model fits the tails of the
empirical distribution. In Figure 4, firstly empirical data is plotted against normal distribution. It can
be seen that data fits normal distribution at the center but significantly deviates in the tails as it is
expected. There is a curve to the top of the right end and to the bottom of the left end indicating higher
values at the right tail and lower returns at the left, emphasizes that the data is fat tailed. In the second
figure, empirical data is compared with GPD. In this figure right tail of the loss distribution (which
consists of exceedances over a given threshold).

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Determination of Threshold Level: Determining the threshold level is a crucial step in extreme value
theory applications. Higher the threshold level is, better the asymptotic features of theory works, since
increasing the number of observations means including more data from the center leads bias in the
parameters. On the other hand, a high threshold level makes the estimators more volatile since we are
left with fewer observations. In this paper, two graphical methods are used to estimate the threshold
level.

Figure 4: QQ-plot(normal distribution)

Mean Excess Plot: Mean excess function is the sum of the excesses over the threshold level ”u”
divided by the number of observations which exceeds the threshold u. Figure 6 shows the values of
mean excess function for each threshold level. To determine the threshold level, we need to find the
interval where the mean excess function becomes a positively sloped linear form, since positively
sloped straight line above a certain threshold u is an indication that the data follows GPD with positive
shape parameter . Figure 6 indicates that threshold level for our data set is between 0.051 and 0.068.

Figure 5: QQ-plot(GPD)

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Hill Plot: As it is mentioned in the previous section Hill Estimator is used to compute tail index .

Figure 6: Mean Excess Plot

Where k is the number of exceedances, n is the sample size and = 1/ is the tail index. Hill plot
is composed of Hill estimators for each threshold level u. A threshold level is selected from the Figure
7, where the shape parameter is fairly stable. For the logarithmic returns in the figure threshold level
is seemed to be in the interval [5.1%, 6.12%]. Checking the QQ –plots of GPD constructed for each
threshold level, it is seen that 5.1 is a better choice in terms of outliers. Therefore threshold level u is
determined as 5.1%.

Estimation: Parameters are estimated in MATLAB, according to theory given in the previous section.
Shape parameter is estimated as 0.0702 and estimated location parameter is equal to 0.0239. Using
these parameter estimations VaR and ES is computed for four different confidence levels, 95%, 97%,
98%, 99%.

Tail VaR ES
95% 0.0488 0.0818
97% 0.0612 0.0952
98% 0.0715 0.1062
99% 0.0896 0.1258

Then VaR and ES are estimated by using the methods given at the beginning.

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Results for four different confidence levels are given below.

Figure 7: Hillplot

VaR 95% 97% 98% 99%

Historical Sim 0.0486 0.0598 0.0681 0.0906
Bootstrap 0.0514 0.0618 0.0739 0.0949
Monte Carlo Sim 0.0556 0.0609 0.0681 0.0799
Var-Cov(Normal) 0.0531 0.0608 0.0665 0.0755
Var-Cov(t-dist) 0.0509 0.0610 0.0692 0.0839
GARCH(1,1) 0.0309 0.0348 0.0395 0.0473
t-GARCH(1,1) 0.0318 0.0379 0.0429 0.0519

ES 95% 97% 98% 99%

Historical Sim 0.0744 0.0875 0.0988 0.1168
Bootstrap 0.0764 0.0901 0.1010 0.1179
Monte Carlo Sim 0.0705 0.0761 0.0800 0.0920
Var-Cov(Normal) 0.0668 0.0735 0.0786 0.0866
Var-Cov(t-dist) 0.0718 0.0829 0.0920 0.1087
GARCH(1,1) 0.0379 0.0417 0.0440 0.0467
t-GARCH(1,1) 0.0446 0.0513 0.0569 0.0671

Values given in the above tables cannot help us to evaluate the methods or to make a relevant
comparison. To achieve this goal forecast power of the models must be compared. This can be done
by backtesting. For this reason, second part of the data set (15.12.2004-01.04.2005) is used. For each
of the given 73 days both VaR and ES values are estimated respectively, by setting a fixed window
length and making a one day ahead forecast. Afterwards risk levels given by VaR and ES are
compared with the observed data.
Before starting the backtest intuitively, we eliminate four methods. We find it more appropriate to
compare only GPD method, GARCH(1,1), t- GARCH(1,1) and Student’ s t distribution approach due

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to the fact that only the methods listed above take the fat tail feature of the data into consideration.
Since it is easier to compare the methods graphically, forecasted values and observations are
represented in the figures below.
First line on the top is ES forecasts. Line in the middle represents the TailVaR values. While TailVaR
follows a more stable path, ES gradually adapts the real data. Both of ES and TailVaR sees no hit in
the tested period. But being more conservative ES offers higher risk capital allocation than TailVaR.

Figure 8: GPD Tail VaR,ES Estimates vs Observed Data

From the below figure it can be seen very clearly that both VaR and ES estimates follows the path of
the original data when the window length is set at 1700 days. Similar to GPD method none of the
estimators underestimates one day ahead risk level, whereas ES can be said to perform better than
expected shortfall offered by GPD.

Figure 9: GARCH(1,1) VaR,ES Estimates vs Observed Data

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The performance of t-GARCH technique can be seen in the figure 10, t-GARCH VaR is the best in
enveloping the movements of losses. As well as VaR, ES has a good performance. While following
the path of observed data it never fails.

Figure 10: t-GARCH VaR,ES Estimates vs Observed Data

In the case of t-distribution VaR and ES estimates cannot adapted the data as well as the previous two
methods and offered risk capital levels are higher than the GARCH and t-GARCH methods.

Figure 11: Students’ t VaR,ES Estimates vs Observed Data

According to the number of hits for the forecast period all four models are approximately same. But it
must be remembered that we are trying to determine the level of risk capital, which is a burden,
amount of money that can be invested to higher return assets. So overestimating the risk capital can be
as expensive as underestimating it. GARCH and t-GARCH seem to perform well in VaR estimations.
Although GPD seriously overestimates the risk in terms of both ES and VaR, the tested period is quite

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stable and there are no significant movements in losses. Remembering whole past crisis, it is natural
for GPD to offer a high risk capital. Of course, optimizing risk capital is important but measuring the
seriousness of underestimation is more important. There are various backtests dealing with this. For
instance Kupeic backtest besides looking to the frequency of underestimation of risk, checks whether
these excess losses are following a binomial distribution or not for the given confidence level (.95).
According to these backtest results observation frequency of failures in t-distribution is 0, in GARCH
0.0137, in t-GARCH 0.0274 and in GPD again 0 for VaR values. When ES is considered Kupeic
backtest gives 0, 0.0137, 0.0137 and 0 respectively. Another backtest concerning the frequency of tail
losses is Lopez backtest. A loss function is defined as a function taking value of 1 if observed loss
exceeds the VaR value and 0 otherwise is defined and then expected value of this loss function is
found. For all of the models this expected value is equal to 0.365. Another comparison statistics can be
root mean squared error which treats excess losses and excess capital in the same way. Estimated root
mean squared errors (RMSE) are given it the table below for both VaR and ES values.

RMSE VaR ES
t-distribution 0.0510 0.0707
GARCH 0.0361 0.0436
t-GARCH 0.0346 0.0469
GPD 0.0500 0.0825

By the figures and the statistics given above, it can be concluded that for the given test period GARCH
and t-GARCH are better than the other models.

4.CONCLUSION

We claimed that one should use alternative risk measures other than VaR, as it is not a coherent risk
measure. However, there is always a trade off between accurate results and the model complication.
Moreover in this case one should also be aware of the fact that coherent measures considered in this
study tend to give unfavorable results for the banks, as it obliges the banks to hold more capital.
In addition, extreme value theory suggests more capital as well for its comparison in their classes. One
can always argue that the extreme value based risk computations are more consistent especially than
the GARCH modeling, as the estimates are very volatile for the latter. That is to say while EVT
method suggests banks to hold stable amount, GARCH model implies a drastically everyday changing
capital.
In terms of the model risk introduced by the models mentioned above, EVT needs more attention
estimating possible threshold parameters. Both the GARCH and EVT modeling become extremely
painful for the multivariate case.

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According to the backtest results EVT modeling is superior to GARCH and t-GARCH models in
terms of Kupeic test, all models are equivalent according to Lopez backtest. On the other hand, it is
obvious that GARCH and t-GARCH models perform better in the 73 day forecast period, since they
have no hit while risk capital offered by these models are lower as root mean square error results
indicates. However, it must be noticed that this 73 day period is quite stable and it is natural that long
term memory of EVT leads higher risk capital levels.

BIBLIOGRAPHY

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