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THEORY

32 VALUE-AT-RISK METHODS AND MODELS...

VALUE-AT-RISK METHODS AND MODELS
AND THEIR APPLICATION
doc. Ing. Tatiana Varcholová, CSc., Ing. Marián Rimarčík
University of Economics in Bratislava, Faculty of Business Economics in Košice

The concept of Value-at-Risk (VaR) was used for loss in the case that the portfolio would have to be
the first time by large financial institutions at the end held for a certain fixed period according to past
of the eighties for measuring risks in portfolios. This experience with a certain rate of certainty (as a rule
period was characterised by huge exchange-rate 95 or 99%). In other words, if the future is like the
volatility and rapid growth in the use of derivatives past, the volume of loss estimated by the risk models
useful for managing currency and interest-rate risks. will occur every 20 days or every 100 days, depen-
Modern derivatives such as forwards, future swaps ding on the degree of certainty set, naturally only if
and options assist in managing exchange-rate and the company does not manage to take preventive
interest-rate volatility. Since these times there has measures in order to reduce such a loss.
occurred a boom in the use of VaR, which has cea- At present various methods exist for determining
sed to be merely a matter of internal interest to finan- VaR, the most important of which are considered to
cial institutions - regulatory authorities have begun to be: the variance-covariance method (also termed the
take an interest in them too. In April 1995 the Basel analytical method), the historical simulation method
Banking Supervision Committee proposed that and the Monte Carlo probability simulation method.
banks in calculating their capital adequacy be ena- The variance-covariance method allows an esti-
bled to apply their own VaR models for market risk mate to be made of the potential future losses of a
with the use of certain parameters determined by the portfolio through using statistics on volatile values in
Committee. Similar measures were implemented in the past and correlations between changes in their
the same year also in the USA: by the Federal values. Volatilities and correlations of risk factors are
Reserve Fund and the Securities and Exchange calculated for a selected period of holding the port-
Commission. The European Commission directive folio and the historical period through using historical
on capital adequacy, which has been in force since data. VaR derives from the distribution of the proba-
1996 has allowed for the use of VaR models for cal- bility of risk factors of change in the value of the port-
culating capital adequacy for positions held in foreign folio, where the simplest models envisage a normal
currencies, where this counted on a rapid expansion distribution of risk factors and their stable correlation.
in the use of VaR also for calculating capital needs In using this method it is necessary to take into con-
for other market risks. sideration in particular the fact that:
• movements in market prices do not have always
VaR methods a normal distribution -they exhibit so-called heavy
tails, which means a tendency to have a relatively
Financial models include a number of ways for more frequent occurrence of extreme values than
expressing risk, which may be used to measure the does a normal distribution,
market risk of a bank, an investment portfolio or • models may not appropriately depict market risk
financial instruments. The most important ways inc- ensuing from extraordinary events,
lude: variance of past yields, standard deviation of • the past is not always a good guide to the future,
yields for a certain previous period, maximum loss in for example correlation forecasts may founder.
a set of possible scenarios, the Monte Carlo compu- The historical simulation method is based on
ter simulation and VaR models. Standard VaR data of losses that a bank would have suffered in a
models include all types of market risks, i.e. interest, given portfolio in a past period. This method is sim-
stock, commodity and currency risks. Successful pler compared to the previous, since it does not
world banks presently use VaR models also for mea- require demanding work breaking down the probabi-
suring credit risk. The further development of the lity of risk factors and determining correlations bet-
application of these models envisages their expansi- ween risk factors. The disadvantage is the need for a
on also for measuring operational and legal risks. sufficient quantity of historical simulations.
VaR models allow an estimate to be made of the The Monte Carlo method is founded on the gene-
value of risk in a portfolio as the maximum volume of ration of a large number of simulations (scenarios) of

BIATEC, Volume XI, 10/2003

changes of the three market factors are favourable. for example. On the day following tion is created through a combination of randomly the concluding of the contract three market factors generated values of risk factors from their probabili. The VaR value is then determined from recently moved toward using special programming the distribution of calculated profits and losses as systems for managing risk. 20 % Application of historical simulation 15 % We will demonstrate the use of historical simulati- on in the example of a forward contract. 10/2003 . Each simula. what value will the forward con- degrees of reliability. euro interest rate and a rise in the koruna interest suring risk are based on different mathematical rate increase the contract’s value. i. the problem however is ove- restimating the reliability of models founded on the Since the forward exchange rate is set so that assumption that these markets will behave in accor- arbitrage is not possible.e. A depreciation of the koruna. dance with past experience. BRIBOR equalling 6. on the types of recorded for the preceding 200 days. we use the histori- ment decisions thus adopted depends also on the cal percentage daily changes of the three factors correctness of input. Since many banks have only ruary 2003. Therefore.. com- and LIBOR equalling 2.808%. the contract is (approx. –––––––––––– 1 + rEUR (1/12) 1 + rSKK (1/12) at risk. The present value of the forward contract is calculated according 0% Profit to the formula: EUR 100 000 EUR 100 000 Existing VaR models are able to calculate a value PV =SSKK/EUR . in particular qualitative. times using the values of the factors of 11 February The use of information technology now provides 2003 and using the daily percentage changes of the almost unlimited possibilities for programming ever factors over the period from 7 May 2002 to 11 Feb- more perfect models. rect” model of measuring risk. 1 Distribution of possible profits and losses on a for- of risk management in the framework of financial ward contract institutions’ integrated information systems are beco- ming the centre of attention among managers.e.16 . changes. the current value of ponents of financial risk in current conditions other BIATEC. 33 the development of a portfolio's value. often however they are not able to correctly estimate the development of risk factors in particular Where: in newly-emerging markets. fit. rEUR – LIBOR euro interest rate then the abnormality of the market's movements is rSKK – BRIBOR koruna interest rate not in itself a problem. at present there are tract have tomorrow. undertaking to pay SKK 5% 42. i. (two interest rates and the koruna’s spot exchange ty distribution. Those program. which we demands in terms of data input. the firm will record a pro- to have an understanding of the overall characteris. an assessment has not the fifth (or first percentile).16 per EUR. It is however important the value will increase. For calculating the VaR of a contract. then on the day of conclu.42% cient evaluation of new. THEORY VALUE-AT-RISK METHODS AND MODELS.e.) zero. –––––––––––– – 42. which a company concluded with a bank on 11 February 10 % 2003 and by which one month later its secures the transfer of EUR 100 000. a fall in the It is important to mention that all models of mea.. models and statistical relationships with varying The question is. define as the fifth (or first) percentile of the distributi- ness of determining the VaR and quality of manage. Volume XI. The current probability distribution as well as the parameters of value of the forward contract is recalculated 200 these distributions. 12 February 2003? If the no preconditions for the definition of a single “cor. on of possible profits and losses. since the correct. i. Examining the causes ding the contract. The result of the simulations is the rate) change. whereby the value of the contract also generation of probability estimates of the VaR. and in the opposite case the firm will record a tics and properties of the models as well as their loss. yet been made of the results of new information The VaR defined as the fifth (first) percentile cor- technology applications in this field. SKK 4 216 000. If financial markets do SSKK/EUR –Spot exchange rate of the koruna not behave in accordance with modelled results. and in the case of the exchange of “global” losses leads us to the fact that for an effi- rates 42. responds to a loss of 23 325 (39 859) koruna ming systems which allow an increase in the quality Fig.03 SKK/EUR.

which will be ever more difficult to handle.. One of the paths to success for a financial institu. Risk gers. management is currently taking on new dimensions.. risks. instruments are necessary. can surable risks with a portfolio of less quantifiable dan. 10/2003 . Conclusion therefore new more effective instruments are requi- red. Only management appropriate to the ongoing globalisati- those financial institutions that best classify possible on changes in society. Objective knowledge and conclusions nevertheless tion is risk management founded upon an evaluation remain essential. The developing approach to risk management cros- ses the boundaries of traditional risk measurement. BIATEC. effectively use modern information technology. primarily with regard to seeking of a set of measurable and non-measurable risks ever more modern approaches to financial risk through using modern information technology. apply modern models for measuring it and ach to risk management supplements a set of mea. The developing appro. which exceeds the boundaries of VaR models. gain a competitive edge and thereby also profit. THEORY 34 VALUE-AT-RISK METHODS AND MODELS. Volume XI.