CALCULATING VALUE AT RISK -VAR

METHODS

All methods have a common base but then diverge in how they actually
calculate Value at Risk (VaR). They also have a common problem in
assuming that the future will follow the past. This shortcoming is
normally addressed by supplementing any VAR figures with appropriate
sensitivity analysis and/or stress testing. In general the VAR calculation
follows five steps
4 mins read time
There are three primary methods used for calculating Value at Risk (VaR).

a. The Variance /Covariance method

b. The Historical simulation method

c. The Monte Carlo simulation method

All VaR methods have a common base but diverge in how they actually calculate Value at Risk
(VaR). They also have a common problem in assuming that the future will follow the past. This
shortcoming is normally addressed by supplementing any VAR figures with appropriate
sensitivity analysis and/or stress testing. In general, the VAR calculation follows five steps:

 Identification of portfolio positions for calculation of Value at Risk

 Identification of risk factors affecting valuation of positions.
 Assignment of probabilities (or statistical distribution) to possible risk factors values.
 Creation of pricing functions for positions as a function of values of risk factors.
 Calculation of Value at Risk (VaR)

Variance Covariance method for Value at Risk

This VaR method assumes that the daily price returns for a given position follow a normal
distribution. From the distribution of daily returns calculated from daily price series we estimate
the standard deviation. The daily Value at Risk VaR is simply a function of the standard
deviation and the desired confidence level. In the Variance-Covariance VaR method, the
 underlying volatility may be calculated either using a simple moving average (SMA) or an
exponentially weighted moving average (EWMA).

Mathematically, the difference lies in the method used to calculate the standard deviation.

This approach is utilized with the assumption that the daily returns during the lookback period
follow a normal distribution. We know that this assumption is not true. Especially under times of
stress and extreme conditions. But we qualify our presentation by including the assumption and
the challenges to its validity in our disclosures.

The SMA approach places equal importance to all returns in the series whereas the EWMA
approach places greater emphasis on returns of more recent duration.

The Variance-Covariance VaR method makes a number of assumptions. The accuracy of the
results depends on how valid these assumptions are. The method gets its name from the variance-
covariance matrix of positions that is used as an intermediate step to calculate Value at Risk
(VaR).

The method starts by calculating the standard deviation and correlation and then uses these values
to calculate the standard deviations and correlation for the changes in the value of the individual
securities that contribute to the position. If price, variance and correlation data is available for
individual securities then this information is used directly. The values are then used to calculate
the standard deviation of the portfolio by matrix multiplication.

Value at Risk (VaR) for a specific confidence interval is then calculated by multiplying the
standard deviation by the appropriate normal distribution factor.

In some cases, a method equivalent to the variance covariance approach is used to calculate
VAR. This method does not generate the variance covariance matrix and uses the following
approach:

1. Separate the portfolio in a long side and a short side.

2. Calculate the return series for the long side and the short side.
3. Use the return series to calculate the correlation and variances for the long and short sides
4. Use the results in (3) to calculate the VaR.

The modified approach can be used where, due to the nature of the institutional strategy, a
number of positions would net close to zero on a portfolio basis and also where the set of
securities employed is so large that a variance – covariance approach would have significant
resource/time requirements.
 Historical Simulation Method for Value at Risk
(VaR)
This approach requires fewer statistical assumptions for underlying market factors. It applies the
historical (100 days) changes in price levels to current market prices in order to generate a
hypothetical data set. The data set is then ordered by the size of gains/losses. Value at Risk (VaR)
is the value that is equaled or exceeded the required percentage of times (1, 5, 10).

Historical simulation is a non-parametric approach of estimating VaR, i.e. the returns are not
subjected to any functional distribution. VaR is estimated directly from the data without deriving
parameters or making assumptions about the entire distribution of the data. This methodology is
based on the premise that the pattern of historical returns is indicative of future returns.

Monte Carlo Simulation for calculating Value at

Risk (VaR)
The approach is similar to the Historical simulation method described above except for one big
difference. The hypothetical data set used is generated by a statistical distribution rather than
historical price levels. The assumption is that the selected distribution captures or reasonably
approximates price behavior of the modeled securities.

A Monte Carlo simulator uses random numbers to simulate the real world. A Monte Carlo VaR
model using the following sequence of steps

1. Generate randomly simulated prices

2. Calculate daily return series
3. Repeat the steps in the historical simulation method described below

Quick Review of Value at Risk (VaR) methods

Historical Monte Carlo
Variance / Covariance VaR
Simulation VaR Simulation VaR

Risks of portfolios No,

that contain options Yes Yes,
except when computed using a
regardless of the regardless of the
short holding period with
 option content limited or moderate option option content
content

No,
VaR Computation
Yes Yes except for relatively
performed quickly
small portfolios

VaR method easy to

explain to senior Yes No No
management

Yes,
Misleading VAR
Yes, except that
estimates when recent
Yes except that alternative alternative
past is not
correlation may be used correlation may be
representative
used

Easy to examine assumptions

about variances and correlation.
Scenario analysis No Unable to examine alternative Yes
assumptions about the
distribution of market factors

Implementing Value at Risk (VaR)

The objective of a Value at Risk (VaR) implementation is to perform daily VaR analysis of
positions within a portfolio. Such a process would be the first step in shifting the current
emphasis from calculating VaR to managing VaR. Within the process the focus should be on:

1. Positions with low coverage levels.

2. Positions with VaR beyond a set threshold.
3. Positions with significant VaR changes.
4. VaR analysis for the Desk. (All clients, All accounts, All positions)

Value at risk – implementation challenges and

recommendation.
From a methodology point of view, the most robust results are likely to come from the historical
simulation approach. This happens because the approach is not handicapped by the normal
distribution assumption. The VCV approach is the most popular approach but also the one with
the most criticism given the normality assumption.
The Monte Carlo approach appears to be fairly attractive but in most simulators the default
distribution used is also normal – which essentially puts the results in the same category and
range as the VCV approach. The big benefit of the simulation approach is when actual trade price
data is not available and prices and returns need to be derived for market factors. This happens
especially when portfolio positions include exotic OTC derivative contracts.

There are a number of tweaks and hacks for building simulators that use the true
distribution rather than a simulated normal distribution.