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FINANCIAL MODELLING

Dr J. Shen

Lecture 6

Risk Measurement

Intended learning outcomes

• Understand the concept of value at risk

• Be able to calculate value at risk using the variance-covariance approach

• Be able to calculate value at risk using the historical simulation approach

• Be able to undertake back testing of value at risk models

Reading

• Kevin Dowd, Beyond Value at Risk, Wiley, 1998. Chapters 2, 3, 4 and 5.

• Philippe Jorion, 2006, Value at Risk: The New Benchmark for Managing Financial Risk, McGraw Hill,

Chapters 5 and 6.

• http://www.gloriamundi.org

2

Introduction

• Risk is inherent in any business activity that involves uncertain cash flows

• There are six main types of risk that firms may face

Business risk: uncertainty over the business environment that is specific to the firm

Market risk: uncertainty over the price of financial assets

Credit risk: uncertainty over the repayment of debt

Operational risk: uncertainty over the internal systems of a company and the people who operate them

Liquidity risk: uncertainty over the ability to find an immediate market for financial assets

Legal risk: uncertainty over the enforceability of legal contracts

• Ignoring risk can have disastrous consequences (e.g. Barings Bank, Orange County, Metallgesellschaft,

Sumitomo Corp, Daiwa Bank, Long Term Capital Management)

3

Value at Risk

• The single most important risk measurement tool is Value at Risk, or VaR, which embodies the market

risk of a portfolio, or indeed of a whole firm, in a single number

• VaR is defined as the maximum loss on a portfolio that can be expected over a certain time interval with

a certain degree of confidence

Example

If a portfolio whose current market value is £10 million has a 10-day 95% VaR of £200,000, then over

the next ten days, with 95% certainty, the largest loss that should be expected is £200,000.

• VaR is therefore (the negative of) the appropriate quantile (or percentile) of the distribution of profit and

loss (or return) of the portfolio

• VaR is a measure of the maximum loss expected from ‘normal’ market movements

• Central to the definition of value at risk is (a) the holding period and (b) the confidence level

• The units of VaR is the units of the portfolio (e.g. GBP, USD or EUR), but that we could write this as a

percentage of the initial portfolio value (i.e. as a return)

4

The Background to Value at Risk

• VaR was first used in the 1980’s by large financial firms to measure the risk of their trading portfolios

• In 1993, the ‘group of thirty’ (a group of 30 prominent US financiers, bankers and academics)

commissioned a report that recommended the use of VaR for all banks to measure the risk of their

derivatives positions

• VaR gained popularity following the launch by JP Morgan in 1994, of Riskmetrics, an integrated package

to enable companies to measure VaR

• In 1996, the Basle Committee on Banking Supervision required banks to set capital requirements

according to ‘internal models’ of market risk, leaving the choice of model to each bank, subject to certain

stringent criteria. Under BCBS recommendations, the estimated VaR for a bank translates directly into

the capital requirements that the bank must meet. The BCBS recommends that banks hold capital equal to

three times the 99% 10-day VaR

• Depending on the effectiveness of the VaR model used, the bank may be required to increase their capital

requirement

• VaR is now widely used not just among banks, but by other financial and non-financial companies

5

The Different Approaches to Calculating Value at Risk

• Assumes a particular distribution for the portfolio return distribution, or for the underlying factors that

drive returns, and uses knowledge of that distribution to compute the appropriate quantile

Historical Simulation

• Uses the historical distribution of portfolio returns in order to compute the appropriate quantile

• Assumes a particular distribution for the underlying factors that drive portfolio returns, and then draws

randomly from these in order to simulate the distribution of portfolio returns

• Recognises that the tails of all fat-tailed distributions have a common shape, which is parameterised by

the tail index, and once this is estimated for a given portfolio, extreme quantiles of the portfolio return

distribution can be calculated

6

The variance-covariance approach

• Assume that continuously compounded (i.e. log) daily returns on the S&P500 are normally distributed

• We can estimate the mean, standard deviation and other statistics of daily returns using historical data

• We could use simple returns, but log returns are more likely to be normally distributed

7

The variance-covariance approach

• The VaR of the portfolio is found by first finding the appropriate percentile of the log return series, i.e.

the log return VaR, under the assumption that log returns are normally distributed

chance that the log return on our portfolio

will be less than –1.34%

8

The variance-covariance approach

• We could also compute this by noting that the percentile of a normal variable is the same as the percentile

of a standard normal variable, transformed by the mean and standard deviation of the variable

ln %VaR = −(c(α ) * σ + µ )

standard normal distribution, σ is the standard

deviation of returns, µ is the mean return

9

The variance-covariance approach

• We can then use this log return to calculate the simple return VaR of our portfolio using the following

formula

chance that dollar loss on out portfolio will

be more than $13.31, or 1.33% of the value

of the portfolio

10

The Variance Covariance Approach

to zero, and so that the log return VaR of the portfolio

is given by

ln %VaR = −c(α ) * σ

result that if returns are serially uncorrelated and

homoscedastic, σ (T ) = T σ and so when µ = 0 ,

11

The Variance Covariance Approach

12

Historical Simulation

• The variance covariance approach relies heavily on the distributional assumptions about portfolio returns.

An alternative approach is to use historical data to compute the quantile of the distribution of the portfolio

value

• In particular, historical simulation takes the distribution of actual daily returns over the previous period,

applies those returns to the current

portfolio to obtain a simulated Histogram of Daily S&P500 Returns

120

distribution of changes in portfolio value

100

of this distribution to estimate value at 60

risk

40

returns is irrelevant with historical

%

0%

0%

0%

0%

0%

0%

0%

40

00

60

20

80

40

simulation), but to be consistent with the

.8

.2

.6

.0

.4

.8

.2

0.

1.

1.

2.

2.

3.

-3

-3

-2

-2

-1

-0

-0

previous example, we use log returns

13

Historical Simulation

the portfolio, we require the 5th percentile of

this empirical log return distribution, which

we can obtain using Excel’s PERCENTILE

function

VaR of the portfolio, as before

variance-covariance approach

14

Historical Simulation

Advantages

Disadvantages

• Cannot be used to estimate the probability of something that hasn’t happened before

15

Back Testing

• Firms have a wide range of models to choose from in their estimation of VaR, and many ways of

implementing each of these models

• If a model systematically understates the true VaR of a firm’s portfolio, then it will hold insufficient

capital to cover unexpected losses

• Back testing involves comparing the forecasts of a VaR model with actual returns, ex post

• The problem is that we do not observe VaR, and so a direct comparison is not possible

• Instead, there are a range of indirect measures of performance that can be used to evaluate the

performance of a VaR model

16

Back Testing

model

• Suppose that we have estimated VaR each day using the previous

1 year (251 days) of data

the VaR model is accurate, the actual return should exceed the

estimated VaR on only 5% (i.e. one minus 95%) of days

if there is a VaR exception, and a ‘0’ if

there is not

17

Back Testing

exceptions and the percentage of exceptions

model is equal to the nominal confidence level, we can use

an LR test

• If p is the nominal significance level (one minus the nominal confidence level), N is the number of

exceptions and T is the total number of observations

[ T −N

LRU = 2 ln ((1 − N / T ) /(1 − p) ) (( N / T ) / p ) N ]

18

Back Testing

• Under the null hypothesis of correct unconditional coverage, the LR statistic has a chi-squared

distribution with one degree of freedom; the critical values for the LR statistic can be obtained from excel

using the CHIINV function

than the critical value, and so we can

not reject at the 5% significance

level the hypothesis that the VCV

model has correct unconditional

coverage

unconditional coverage and

independence, there are many other

measures that can be used to evaluate

a VaR model

• Some of these measures evaluate the conditional coverage of the VaR model, in other words whether

VaR exceptions are forecastable. Others evaluate the forecast of the entire density of portfolio returns,

rather than just a single quantile

19

Back Testing

• Back testing results are used by the BCBS in conjunction with the bank’s estimate of VaR in order to set

the bank’s capital requirements

• The benchmark capital requirement is three times the estimated 99% 10-day VaR, but a ‘penalty’ capital

requirement that depends on its unconditional coverage

• Using a back testing sample of 250 days, the capital requirement for a bank is increased from three to up

to four times the estimated VaR depending on the number of exceptions recorded

0 to 4 3.00

5 3.40

6 3.50

7 3.65

8 3.75

9 3.85

10 or more 4.00

20

Volatility Clustering

• A particular feature of virtually all short horizon financial asset returns is that they display volatility

clustering: large returns (of either sign) tend to be followed by more large returns; small returns (of either

sign) tend to be followed by more small returns

• Allowing for volatility clustering should improve VaR estimates, since if we know we are currently in a

high volatility period, our VaR estimates should be correspondingly higher

• In order to incorporate volatility clustering into the calculation of VaR, we need a model of time-varying,

or conditional, volatility

• The simplest model of time-varying volatility is a rolling window estimator; more sophisticated models

include EWMA and GARCH

21

Incorporating Volatility Clustering into VaR estimates

• To incorporate volatility clustering into the variance-covariance approach involves replacing the

unconditional estimate of volatility with the conditional volatility from the model

ln %VaRt = −c(α ) * σ t

• To incorporate volatility clustering into historical simulation, we compute the empirical quantile of the

historical standardised distribution (i.e. the distribution of returns scaled by each day’s estimated standard

deviation from the model) and then scale this up by the model’s forecast of tomorrow’s standard

deviation

• To incorporate volatility clustering into Monte Carlo simulation, we simply draw randomly from a pre-

specified distribution with an estimate of the conditional volatility from the model

22

Practical exercise 6

You are a risk management analyst for an investment bank. Your manager wants you to compute the 60%,

90% and 99% VaR for a position in 50,000 December 2009 call options on Apple, with an exercise price of

185.00. The VaR horizon is the maturity of the option contract. She would also like you to compute the VaR

for a portfolio of the underlying shares.

You decide to estimate VaR using Monte Carlo simulation. Monte Carlo simulation proceeds by generating

simulated price paths for the underlying asset, valuing the option portfolio at the VaR horizon for each of

these simulated price paths, and using the distribution of portfolio values across all the simulated price paths

in order to estimate the portfolio VaR.

1. Obtain the option price, associated underlying share price and time to expiry from www.cboe.com.

2. Obtain daily data for the underlying share from finance.yahoo.com. Use this to calculate daily log returns

and estimate daily volatility.

3. To simulate the stock price on day t, St , you decide to use the following process

ln St = ln St −1 + σε t

23

where σ is the daily volatility of log returns and ε is a standard normal variable (i.e. a normally

distributed variable with a zero mean and unit variance). Note that we are assuming that the mean log

return is equal to zero as we are considering only a very short horizon.

We can therefore simulate the stock price by generating a series of standard normal variables, and

applying the above formula. Use the random number generator in Excel (Data/Data Analysis/Random

Number Generation) to generate 1000 realizations of a standard normal random number for each day.

4. Using the simulated values of ε , the initial stock price, S 0 , and your estimate of daily volatility, σ ,

compute the series for ln S t for each realisation. Compute also the series St . Plot all the simulated series St .

5. Using the simulated value of ST (the price of the share at the expiry date of the option), compute the value

of the option, CT at expiry.

6. Using the simulated values of ST and CT , compute the simple return on the share portfolio and the option

portfolio for each realisation. Use these returns to compute the VaR for the share portfolio and the option

portfolio. Plot the empirical distributions of the share and option returns.

24

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