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VALUE AT RISK & EXPECTED

SHORTFALL
A K MISHRA
Sih) — Faculty, Department of Economics
K K Birla Goa Campus
Introduction
“Value at risk (VaR) and expected shortfall (ES) are
attempts to provide a single number that summarizes the
total risk in a portfolio.
“VaR was pioneered by JPMorgan and is now widely used
by corporate treasurers and fund managers as well as by
financial institutions.
“It is the measure regulators have traditionally used for
many of the calculations they carry out concerned with the
setting of capital requirements for market risk, credit risk,
and operational risk.
“*A measure that can produce better incentives for traders
than VaR is expected shortfall (ES).
Introduction
“eExpected shortfall (ES)-This is also sometimes
referred to as conditional value at risk, conditional
tail expectation, or expected tail loss.
“* Whereas VaR asks the question: “How bad can
things get?”
“*ES asks: “If things do get bad, what is the expected
loss?”
“ES, like VaR, is a function of two parameters:
¢*T (the time horizon) and
“+X (the confidence level).
VaR-Introduction
“VaR is used by many large financial institutions to
measure the riskiness of their holdings and determine sajfe
levels of capital to hold.
“* VaR gives the risk manager a sense of what he or she can
expect to potentially lose in a given time interval, assuming
“normal” market conditions.
“The main role of value at risk (VaR) is to provide
summary information on the risk of a firm, a portfolio, or a
stock.
“* This information is generally given to a firm's top
management or to a portfolio manager or stockholder or
regulatory agencies.
VaR-Introduction
“When using the value at risk(VaR) measure, we are
interested in making a statement of the following form:
““We are X per cent certain that we will not lose more than
V dollars in time T.”
“Two elements are required to compute VaR:
1) Specified time period/ Time horizon-T
2) Confidence level- the quantile the risk manager uses to
calculate the VaR(X).
VaR-Introduction
“Note: The confidence level determines how sure a risk
manager can be when they are calculating the VaR.
“The confidence level is expressed as a percentage, and it
indicates how often the VaR falls within the confidence
interval.
“*If a risk manager has a 95% confidence level, it indicates he
can be 95% certain that the VaR will fall within the
confidence interval.
“* Example: Assume that a risk manager determines the 5%
one-day VaR to be $1 million.
“*This means that he has a 95% confidence level that the
worst daily loss will not exceed $1 million.
VaR-Example
“VaR is the maximum loss calculated for a given time
period at a certain confidence level.
“VaR can be calculated from either the probability
distribution of gains during time T or the probability
distribution of losses during time T.
“(In the former case, losses are negative gains; in the latter
case, gains are negative losses)
“Example: when T=5 days and X =97%, VaR is the /oss at
the 3rd percentile of the distribution of gains over the next
five days.
“Alternatively, it is the loss at the 97th percentile of the
distribution of losses over the next five days.
VaR-Example
“VaR is the maximum loss calculated for a given time
period at a certain confidence level.
“*More generally, when the distribution of gains is used,
VaR is equal to minus the gain at the (100—X)th percentile
of the distribution.
“eo Figure 1: Calculation of VaR from the Probability Distribution of the Gain in
the Portfolio Value [Losses are negative gains; confidence level is X%; VaR level is
Vv)

(100
— X)%

Loss -V Gain
VaR-Example
“VaR is the maximum loss calculated for a given time
period at a certain confidence level.
“¢On the other hand, when the distribution of losses is used,
VaR is equal to the loss at the Xth percentile of the
distribution.
“eo Figure 2: Calculation of VaR from the Probability Distribution of the Loss in
the Portfolio Value [Gains are negative losses; confidence level is X%; VaR level is
Vi.

(100
— X)%

Gain V Loss
VaR-Example
“Example: <A 3% VaR of $50 over the next 1
week would mean that a minimum loss that would
occur within the next 1 week is $50 and the probability
of this loss is 3%.
“*In other words, there is 97% chance that our loss will
not exceed $50 within the next 1 week.
~* Example: The average return u=1.23%, and the
standard deviation 0=4.3%. °
“Figure 3: Monthly returns |
of a global portfolio p°
s
>

6
VaR-Example
“* Example: Contd... |
“Figure 3: The average return H=1.23%,)° litt
“¢ The standard deviation 0=4.3%. 4 LH I |

“*The VaR calculates, the maximum amount that a portfolio

manager can lose during the next month with a confidence
level of (X).
“* The relative parametric VaR can be written as follows:
VAR, =A0V At ----------------=== oon nnn nnn nnn nnn nnn nnn (1)
“* where o= the SD of the distribution and At measures the
temporal variation, which we suppose is presently equal to
1 ( with a=1.65 for a confidence level of X=95%).
VaR-Example
“* Example: The average return U=1.23%,
“* The standard deviation 0=4.3%.
*VaR,,=a0V At-------------------------------------------------- (1)
“* where o =SD of the distribution and At =temporal
variation(=1).
“«* The value X is the chosen confidence level (~@=1.65 for a
confidence level of X¥=95%).
“* VaR,., is the VaR relative to the average.
“*It covers the losses and the expected returns.
“* VaR,, at 95% confidence level is equal to:7.1%(=1.65 x
4.3%).
VaR-Example
“Example: U=1.23%, 0=4.3%.
VaR, =A0\ At-----n----n nnn nnn nnnn nnn nn nnn nnn noone ene (1)
“*VaR,., 1s the VaR relative to the average.
“VaR,, at 95% confidence level is equal to:7.1%.
¢* On the other hand, the absolute VaR only takes losses into
account:
“+ VaRq.=aovVAt — uw = VaR; —[ ----------------------------- (2)
“*The absolute VaR corresponds to Vak,, from which we
subtract the average of the distribution.
“* We can verify that VaR,,=7.1% — 1.23% = 5.9% of return
loss.
VaR-Example
“Example: VaR,, =7.1% relative to the average &
VaRq.=5.9% of return loss.
¢¢ Figure 4:VaR(Two values at risk when we do not reject
that the returns in the histogram are normally distributed )
+.
+,
Given a $100 million initial +

portfolio, the maximum loss Frequency

calculated with a confidence
level of 95% is $7.1 million
over the course of the next
month, while the average
expected return is $1.23
million. VaR,
The VaR can be used to
create a capital reserve in VaR.
order to protect against the
worst possible unanticipated
outcome at a confidence level ‘ >

of 95%. 5.9% —3.07% Q 1.23% §.53% Monthly

return
VaR-Computational Procedures
“*There are many ways to calculate the VaR.
“* NUMERICAL METHOD:
“* This method consists of using the histogram of returns
over a given time period.
“* Figure 5: Histogram of JP Morgan's daily revenue in
1995(N=250 days)
20
18
16
2 14
3 12
Number of

10
Ow
con
fF HD

30 -26 -22 -18 -14 |-10 -6 -2 2 6 10 #14 18 22 26 30

R* Daily revenue (M$)
VaR-Computational Procedures
“* NUMERICAL METHOD:
“Figure 5: Histogram
of JP Morgan's daily revenue ="
in 1995 (N=250 days)
TTT Tr TE TTTT TT T T TITTT
|
TPT TTT tT tT
Lila 1
26 30

“*Theu=average income is $7.6 million.

“¢ Most of the observations are
between —$15 million and $30 million.
“There is even one daily loss greater than $26 million.
“eIf we choose a confidence level of X=95% to calculate the
VaR, this implies that we are covering 95% of potential
values.
VaR-Computational Procedures
“* NUMERICAL METHOD:
“Figure 5: Histogram 3 |
Morgan's daily revenue a i
days). ‘ |
ys) _ aa call i | IL tN Chiba
“UL — $7.6 million(M). “ees 4 re cetera os oes

“*If we choose a confidence level of X =95% to calculate the VaR, this

implies that we are covering 95% of potential values.
«+ There is a 5% probability that the maximum loss calculated or VaR
will be surpassed; the firm thus has five chances in a hundred of
surpassing the maximum loss calculated over the next 100
transaction days (if the distribution remains stable).
“The maximum value calculated is a daily loss of $11.4 million (5% of
250 observations=12.5 observations from the left).
“VaRg.= aovVAt — u = VaR, — [l --------------------------
=== === == === == (2)
VaR-Computational Procedures
“* NUMERICAL METHOD:
“*Figure 5: Histogram

Number of days
Morgan's daily revenue
days).
“9 LL —_— $7.6 M. 30 -26 -22 -I18 14 [-10
i
“ily evenae (ns) 10
| | «18i I 22 Brrr
14 26
R*

“The maximum value calculated is a daily loss of $11.4 M (5% of 250

observations=12.5 observations from the left). i,.e., VaR,,.= $11.4 M
«*Absolute VaR corresponds to the maximum loss with respect to zero.
«*Now, if we wish to calculate the maximum loss with respect to the
mathematical expected revenue, E(R),VaR is: VaR,,=VaR,,+ ----(2)
“¢ Thus, to protect itself, the firm must create a $19 million capital
reserve.
“* However, this numerical method is not frequently used in practice
due to its lack of precision.
VaR-Computational Procedures
“* PARAMETRIC METHOD:
“* Let us denote V as the returns and f(V) as the density
function of the distribution.
“*We may define the probability that V is less than V*, where
V* is defined by the chosen confidence level X%, so that
VaR=V*=the maximum loss quantile= minus the gain at the
(100-X)th percentile of the distribution.
“*¢ The probability p = 1 — (—) that V <-V* is:

“ F(V*) = problV < -V*]=f". fav =p

VaR-Computational Procedures
“* PARAMETRIC METHOD:
“* Let us denote V as the returns and f(V) as the density
function of the distribution.
“F(V*) = probl[V < -V*]=f" f(V)av =p
“* where F(V) is the cumulative distribution function.
“*In order to calculate parametric VaR, we now need to make
an assumption about the distribution of V.
“* Let’s assume that the portfolio return is normally
distributed with mean=y and variance=o~%,then, we can solve
for V* such that:
** FE (V*) =Prob(V <-V*) = j—= e Vm 20" dy = p
* ve 2 2
+

*,OVN20
VaR-Computational Procedures
“* PARAMETRIC METHOD:
“Let's assume that the portfolio return is normally
distributed with mean=y and variance=o%,then, we can solve
for V* such that:
“ F(v*) =Prob(y <V*) = [ —e "gv = p
“* The standard normal distribution table directly gives us the
—c0 Oo 7. e . e ° ®

value of the limit variable (Z*) corresponding to V*, and

associated with the given confidence level.
“*For example, for a confidence level of 95%, the variable Z*=
-1.645, or Prob. (Z < —Z*)=0.95.
“eIt is therefore beneficial to transform V in order to obtain Z
V-

where: Z = —,
VaR-Computational Procedures
s PARAMETRIC METHOD:
“¢The standard normal distribution table directly gives us the
value of the limit variable (Z*) corresponding to V*, and
associated with the given confidence level.
“*It is therefore beneficial to transform V in order to obtain Z
V—-—

where: Z = —,

“*Consequently, if we write F(Z*) as the standard normal

distribution function of Z: F(Z*) = Pr(Z < —Z*)=0.05
“* >Pr(Z < —1.645)=0.05
* = Pr|z —(—*)| = 0.05
O

“ >F-1(0.05)=-1.65
“=> V*= pb — 1.650. https://keisan.casio.com/exec/system/1180573190
VaR-Computational Procedures
s PARAMETRIC METHOD:
“*Example: Contd... u=1.23%, 0=4.3%.
VaR, = —V* = F71(0.05) *o = 1.650 — pn = 5.9%
“VaR, =n —V*=1.650 = VaR, — b= 7.13%
“* Example: Suppose that the gain from a portfolio during
six months is normally distributed with a mean of $2 million
and a standard deviation of $10 million. Given a confidence
level of 99%, calculate the VaR for the portfolio.
“* Here, F~1(0.01)=-2.33. = VaRg, = —V*=2.330 —u
“*The VaR for the portfolio with a time horizon of six months
and confidence level of 99% is therefore $21.3 million.
VaR-Computational Procedures
“Delta Normal VaR: One of the simplest and easiest ways
to calculate VaR is to make what are known as delta-normal
assumptions.
“* For any underlying asset, we assume that the log returns
are normally distributed and we approximate the returns of
any option using its delta-adjusted exposure.
“* The delta-normal assumptions make it very easy to
calculate VaR statistics even with limited computing power.
“* This made delta-normal models a popular choice when VaR
models were first introduced.
VaR-Computational Procedures
“¢Delta Normal VaR:
“*To calculate the delta-normal VaR of a security, we start by
calculating the standard deviation of returns for the security
or, in the case of an option, for the returns of the option’s
underlying security.
“* For regular securities, we then multiply the return standard
deviation by the absolute market value or notional of our
position to get the position’s standard deviation.
“* For options we multiply by the absolute delta-adjusted
exposure.
VaR-Computational Procedures
“* Delta Normal VaR:
“* The delta adjusted exposure of a single option being the
underlying security's price multiplied by the option’s delta.
“* We then multiply the position’s standard deviation by the
appropriate factor for the inverse of the standard normal
distribution (e.g. —1.64 for 95% VaR).
“* Note: About the expected return.
“*In practice, most VaR models assume that the distribution
of returns has a mean of zero.
“¢This is almost always a very reasonable assumption at short
horizons.
“*At longer horizons this assumption may no longer be
reasonable.
VaR-Computational Procedures
“* Delta Normal VaR:
“* Example: You estimate the standard deviation of daily
returns for XYZ Corp.’s stock at 2.00%. You own both the
stock and a call option on the stock with a delta of 40% and
1-day theta of —0.01. The underlying price is $100. Calculate
the one-day 95% daily VaR for each security.
“*AnSwer: The 95% VaR corresponds to the bottom 5% of returns. For a normal
distribution 5% of the distribution is less than 1.64 standard deviations below the
mean. —1.64, the negative sign indicating that the result is below the mean.
“*For the stock, the final answer is simply: -1.64 x $100 x 2.00% = —$3.28. (If you use
additional decimal places for the standard deviation, you might get —$3.29.)
“*For the option, the final answer is only slightly more complicated: -1.64 x 40% x
$100 x 2.00% — 0.01 = —$1.32.
“The 1-day 95% daily VaR for the stock and option are a loss of $3.28 and $1.32,
respectively.
VaR-Computational Procedures
“* HISTORICAL VaR:
“Another very simple model for estimating VaR is historical
simulation or the historical method.
‘“eIn this approach we calculate VaR directly from past
returns.
“*Example: Suppose we want to calculate the one-day 95%
VaR for an equity using 100 days of data.
“The 95th percentile would correspond to the least worst of
the worst 5% of returns.
“In this case, because we are using 100 days of data, the VaR
simply corresponds to the fifth worst day.
VaR-Computational Procedures
“* HISTORICAL VaR:
“* Now suppose we have 256 days of data, sorted from lowest
to highest as in the given Table 1: 95% Historical VaR
°
*° Y
We still want to calculate the 95%
R Cum. Weight(%)
VaR, but 5% of 256 is 12.8.
Worst 1 —34.3% 0.4%
v Should we choose the 12th day? The 2 28.9% 0.8%
13th? 3 —25.0% 1.2%
v The more conservative approach is to 4 —24.9% 1.6%

take the 12th point, -15.0%. 10 -15.9% 3.9%

Another alternative is to interpolate 11 -15.5% 4.3%

between the 12th and 13th points, to 12 —-15.0% 4.7%

13 -14.9% 5.1%
come up with -14.92%.
Unless there is a strong justification 254 21.4% 99.2%

for choosing the _ interpolation 255 23.0% 99.6%

Best 256 28.1% 100.0%
method, the conservative approach is
recommended.
VaR-Computational Procedures
“* HISTORICAL VaR:
«One advantage of historical VaR is that it is
extremely simple to calculate.
“*Another advantage is that it 1s easy to explain to
non-risk professionals.
“The inputs to historical VaR should be familiar to
anybody working in finance.
“* For equities, for example, the inputs are just the
historical returns.
VaR-Computational Procedures
“* HISTORICAL VaR:
“If there is ever a question about the validity of a
historical VaR calculation, it is easy enough to pull
up a chart of historical returns to look for a potential
source of error.
“* Unlike parametric models which are based on
distributions often make it easier to draw general
conclusions, in the case of the historical approach, it
is difficult to say if the data used for the model are
unusual because the model does not define usual.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“* Monte Carlo simulations are widely used throughout finance,
and they can be a very powerful tool for calculating VaR.
“*Monte Carlo Simulations correspond to an algorithm that
generates random numbers that are used to compute a
formula that does not have a closed (analytical) form
“*This means that we need to proceed to some trial and error
in picking up random numbers/events and assess what the
formula yields to approximate the solution.
“*Drawing random numbers over a large number of times (a
few hundred to a few million depending on the problem at
stake) will give a good indication of what the output of the
formula should be.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
«Computing VaR with Monte Carlo Simulations is very
similar to Historical Simulations.
“*The main difference lies in the first step of the
algorithm — instead of using the historical data for the
price (or returns) of the asset and assuming that this
return (or price) can re-occur in the next time interval,
we generate a random number that will be used to
estimate the return (or price) of the asset at the end
of the analysis horizon.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“Steps for calculating VaR using Monte Carlo simulations.
“*Step 1 — Determine the time horizon t for our analysis and
divide it equally into small time periods, i.e. At=dt = t/n).
“* For illustration, we will compute a monthly(n) VaR consisting
of twenty-two(t) trading days.
“*Therefore, n = 22 days and dt = 1.
“The main guideline here is to ensure that ot is large enough
to approximate the continuous pricing we find in the financial
markets.
“¢This process is called discretization, whereby we approximate
a continuous phenomenon by a large number of discrete
intervals.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“Steps for calculating VaR using Monte Carlo simulations.
“Step 2 —Draw a random number from a random number
generator and update the price of the asset at the end of the first
time increment.
“*It is possible to generate random returns or prices.
“*In most cases, the generator of random numbers will follow a specific
theoretical distribution.
“*This may be a weakness of the Monte Carlo Simulations compared to
Historical Simulations, which uses the empirical distribution.
“*When simulating random numbers, we generally use the normal
distribution.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“Steps for calculating VaR using Monte Carlo simulations.
“Step 2 —Draw a random number from a random number
generator and update the price of the asset at the end of the first
time increment.
“* Most often, we use the standard stock price model to simulate the path of a
stock price from the i day as defined by: R =(s.,, -S,)/S, = Att oeVAt
«* R. is the return of the stock on the ith day
«* S. is the stock price on the ith day
“*S.,, 1s the stock price on the i+1th day
“*u is the sample mean of the stock price
“*Ot is the timestep
“*o is the sample volatility (standard deviation) of the stock price
“ee is arandom number generated from a normal distribution
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“Steps for calculating VaR using Monte Carlo simulations.
“Step 3 — Repeat Step 2 until reaching the end of the analysis
horizon T by walking along the N time intervals.
“At the next step/day (Ot= 2), we draw another random number
and determine S.,, from S,,, using the same equation.
“*We repeat this procedure until we reach T and can determine
Sit:
“* In our example, S.,.., represents the estimated (terminal) stock
price in one month time of the sample share.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“Steps for calculating VaR using Monte Carlo simulations.
“Step 4 —Repeat Steps 2 and 3 a large number M of times to
generate M different paths for the stock over T.
“*So far, we have generated one path for this stock (from i to 1+22).
“*Running Monte Carlo Simulations means that we build a large number MV
of paths to take account of a broader universe of possible ways the stock
price can take over a period of one month from its current value (S,) to an
estimated terminal price i+T.
“°S.,7 1s only one possible terminal price for the stock amongst an infinity.
“*Indeed, for a stock price being defined on (a set of positive numbers), there
is an infinity of possible paths from Si to S;,,.
“*It is an industry standard to run at least 10,000 simulations even if 1,000
simulations provide an efficient estimator of the terminal price of most
assets.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“Steps for calculating VaR using Monte Carlo simulations.
“Step 5 —Rank the M terminal stock prices from the smallest to
the largest, read the simulated value in this series that
corresponds to the desired (1-p)% confidence level (say, 95% or
99%) and deduce the relevant VaR, which is the difference
between S, and the pth lowest terminal stock price.
** Example: Let us assume that we want the VaR with a 99% confidence interval.
“*In order to obtain it, we will need first to rank the M terminal stock prices from the lowest
to the highest.
“*Then we read the 1% lowest percentile in this series.
“*This estimated terminal price, S,,,,1% means that there is a 1% chance that the current
stock price S; could fall to S,,,1% or less over the period in consideration and under
normal market conditions.
“If S..1% is smaller than Si (which is the case most of the time), then S.—S.,,1% will
corresponds to a loss. This loss represents the VaR with a 99% confidence interval.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“Example: Assume that you run a series of 10,000 simulations and
derive corresponding values for the portfolio.
“* These values can be ranked from highest to lowest, and the 95%
percentile VaR will correspond to the 500th lowest value and the 99th
percentile to the 100th lowest value.
“* Example: How we would calculate VaR with 95% confidence level
using a Monte Carlo simulation(1000 runs/simulations) based on daily
log returns of gold(assumed to be normally distributed with average
return U=0.01% & the standard deviation o=1.4%).
“*To calculate the VaR of this position, we could generate 1,000 draws
from a normal distribution with a mean of 0.01% and a standard
deviation of 1.40%, convert the log returns into standard returns, and
then sort the returns from lowest to highest.
“*Then, we simply select the 50th worst return from the list.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“*The basic idea is very simple, but there are some important
details to keep in mind.
“* First, generating multi-period returns this way involves
what we call sampling with replacement.
¢*Pretend that the first draw from our random number
generator is a 10, and we select the 10th historical return.
“¢ We don't remove that return before the next draw.
“If, on the second draw, our random number generator
produces 10 again, then we select the same return.
“*If we end up pulling 10 four time in a row, then our four-day
return will be composed of the same 10th return repeated four
times.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“*The second detail that we need to pay attention to is serial
correlation and changes in the distribution over time.
“*We can only generate multi-period returns in the way just
described if single-period returns are independent of each
other and volatility is constant over time.
“* Suppose that this was not the case, and that the previous
example relating to gold tends to go through long periods of
high volatility followed by long periods of low volatility.
“*Now assume that by chance, the historical data we are using
starts with 250 days of low volatility followed by 250 days of
high volatility.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“Serial correlation and changes in the distribution over time.
‘“*If we randomly select returns with replacement, then the
probability of getting a draw from the high-volatility period is
1/2 each time.
“* If our random numbers are generated independently, then
there is only 1/16 = (1/2)4 chance of drawing four returns in a
row from the high period, whereas, historically, the
probability was much closer to 1/2.
“*A simple solution to this problem: Instead of generating a
random number from 1 to 500, generate a random number
from 1 to 497, and then select four successive returns.
VaR-Computational Procedures
“MONTE CARLO SIMULATION:
“*Of the three methods we have considered so far, Monte Carlo
simulations are generally considered to be the most flexible.
“¢ Their major drawback is speed. [As computers get faster and
faster, the speed of Monte Carlo simulations is becoming less
of an issue].
“*Still in some situations— a trading desk that require real-time
risk numbers, for example—this speed issue may still rule out
the use of Monte Carlo simulations.
VaR-Advantages & Drawbacks
“*There are many reasons why VaR has become so
popular in risk management.
“*First, VaR is widely used because of its simplicity.
“Second, since it boils risk down to a single number,
VaR also provides us with a convenient way to track
the risk of a portfolio over time.
“* Third, it focuses on losses. This may seem like an
obvious criterion for a risk measure, but variance
and standard deviation treat positive and negative
deviations from the mean equally.
VaR-Advantages & Drawbacks
“Fourth, VaR also seems to strike the right balance, by
focusing on losses that are significant, but not too extreme.
“Fifth, VaR also allows us to aggregate risk across a portfolio
with many different types of securities (e.g., stocks, bonds,
futures, options, etc.).
¢ Finally, VaR is robust to outliers. As is true of the median or
any quantile measure, a single large event in our data set (or
the absence of one) will usually not change the estimate of
VaR.
¢ This advantage of VaR is a direct consequence of one of its
deepest flaws, that it ignores the tail of the distribution.
¢ Expected shortfall, a closely related measure, has exactly the
opposite problem: It incorporates the tail of the distribution,
but it is not robust to outliers.
VaR-Limitations
“VaR ignores the tail of the distribution
“The sort of probability distribution of gains that the trader might aim
for is shown in Figure 6.
“*The VaR in Figure 6 might be the same as the VaR in Figure 1.
“¢ But the portfolio in Figure 6 is much riskier than the portfolio in
Figure 1 because a large loss ts more likely.

in the Portfolio in Portfolio Value

Value [Losses are negative gains; during Time T [Confidence Level is
confidence level is X%; VaR levelis | X%. Portfolio has the same VaR
va level, V, as in Figure 1,
F

(100 — X)% (100 —X )%

Loss -V Gai
am Loss -V Gain
COHERENT RISK MEASURES
“A sensible risk measure in finance must be consistent with
the basic theory in finance.
“¢In 1999, Philippe Artzner and his colleagues proposed a set
of axioms that they felt any logical risk measure should
follow.
“They termed a risk measure that obeyed all of these
axioms coherent.
“*As we will see, while VaR has a number of attractive
qualities, it is not a coherent risk measure.
“The four axioms that a coherent risk measure must obey
are monotonicity, positive homogeneity, translation
invariance, and subadditivity.
COHERENT RISK MEASURES
“Let n be a risk measure.
“We say that 7) is coherent if it satisfies the following
four conditions :
1. Monotonicity: If X = Y for all possible outcomes,
then n(X) = n(Y).
2. Translation invariance: For any positive constant
c, n(X +c) =n(X) +c.
3. Positive homogeneity: For any positive constant c,
n(cX) = en(X).
4. Subadditivity: n(X + Y) < n(X) + n(Y).
COHERENT RISK MEASURES
>Monotonicity: If a portfolio produces a worse result than
another portfolio for every state of the world, its risk
measure should be greater.
“*Let’s assume that we have two portfolios, Portfolio X and Portfolio Y.
“*If Portfolio X loses more money than Portfolio Y in all scenarios, then
Portfolio X should be considered riskier.
“If Portfolio X loses the same amount as Portfolio Y in all scenarios
except one where it loses more, then Portfolio X should still be
considered riskier.
“* Thus, ifX = Y for all possible outcomes, then n(X) = n(Y).
“eA risk measure that obeys this logic is said to be monotonic, or to
display monotonicity.
“*VaR is a monotonic risk measure.
COHERENT RISK MEASURES
>»Translation invariance: The translation invariance means that
there is no additional risk if there is no additional uncertainty,
because in statistics adding a constant to a random variable does not
affect its variability.
¢* A portfolio composed solely of risk-free assets—cash or short-term
Treasuries, for example—has, by definition, zero risk.
“*If we add an amount of cash equal to C to a portfolio, the cash
provides a buffer against losses and should reduce the capital
requirement by C.
¢*Adding or subtracting risk-free assets to a portfolio should not alter
the risk of that portfolio.
«*A risk measure that is unaltered by the addition or subtraction of a
risk-free asset is said to obey translation invariance.
“*Thus, for any positive constant c, n(X + c) = n(X) + ¢.
“*Both standard deviation and VaR are translation invariant.
COHERENT RISK MEASURES
>» Positive homogeneity: Imagine that you double the size of
all the positions in your portfolio. The returns in all
scenarios will also be doubled, and you should consider the
new portfolio to be twice as risky.
“* More generally, if you multiply all outcomes by a constant,
c, and the associated risk measure is c times as great, then
the risk measure is said to display positive homogeneity.
“*For any positive constant c, n(cX ) = cn(X).
COHERENT RISK MEASURES
> Subadditivity: The subadditivity states that the risk measure for a
combined position should not be greater than risks of the two
positions treated separately.
“The risk of a diversified portfolio should not be greater than risks of
the individual components.
“*Thus, subadditivity simply expresses the fact that there should be
some diversification benefit from combining risks.
“* Thus, n(X + Y) < n(X) + n(Y).
¢* In other words, the risk of the combined portfolio, (X+Y), is less
than or equal to the sum of the risks of the separate portfolios.
“+ Variance and standard deviation are subadditive risk measures.
“*VaR, does not always satisfy the requirement of subadditivity.
“*The following example demonstrates a violation of subadditivity for
VaR.
COHERENT RISK MEASURES
Example: Suppose each of two independent projects has a
probability of 0.02 of a loss of $10 million and a probability of 0.98 of a
loss of $1 million during a one-year period.
The one-year, 97.5% VaR for each project is $1 million.
When the projects are put in the same portfolio, there is a 0.02 x 0.02
= 0.0004 probability of a loss of $20 million, a 2 x 0.02 x 0.98 =
0.0392 probability of a loss of $11 million, and a 0.98 x 0.98 = 0.9604
probability of a loss of $2 million.
The one-year 97.5% VaR for the portfolio is $11 million.
The total of the VaRs of the projects considered separately is $2
million.
The VaR of the portfolio is therefore greater than the sum of the VaRs
of the projects by $9 million.
This violates the subadditivity condition.
COHERENT RISK MEASURES
Example: Imagine a portfolio with two bonds, each with a
4% probability of defaulting. The bonds are currently worth
$100 each. If a bond defaults, it is worth $0; if it does not, it
is worth $105. Assume that default events are uncorrelated.
What is the 95% VaR of each bond separately? What is the
95% VaR of the bond portfolio?
For each bond separately, the 95% VaR is —§5. For an individual bond,
in (over) 95% of scenarios, the bond increases in value by $5. In the
combined portfolio, however, there are three possibilities, with the
following probabilities:
P[x] x
0.16% —$200
7.68% —$100
92.16% $10
COHERENT RISK MEASURES
Example: Imagine a portfolio with two bonds, each with a
4% probability of defaulting. The bonds are currently worth
$100 each. If a bond defaults, it is worth $0; if it does not, it
is worth $105. Assume that default events are uncorrelated.
What is the 95% VaR of each bond separately? What is the
95% VaR of the bond portfolio?
As we can see, there are no defaults in 92.16% = (1 — 4%)? of
the scenarios. In the other, 7.84% of scenarios, the loss is
greater than or equal to $100. The 95% VaR of the portfolio
is therefore $100.
Because the VaR of the combined portfolio is greater than
the sum of the VaRs of the separate portfolios, it seems to
suggest that there is no diversification benefit.
Expected Shortfall
“eA measure that can produce better incentives for traders
than VaR is expected shortfall (ES).
¢¢This is also sometimes referred to as conditional value
at risk, conditional tail expectation, or expected tail loss.
“¢ Whereas VaR asks the question: “How bad can things
get?”
“ES asks: “If things do get bad, what is the expected
loss?”
“ES, like VaR, is a function of two parameters: T (the
time horizon) and X (the confidence level).
“Indeed, in order to calculate ES it is necessary to
calculate VaR first.
Expected Shortfall
“One criticism of VaR is that it does not tell us anything
about the tail of the distribution.
“*Two portfolios could have the exact same 95% VaR but
very different distributions beyond the 95% confidence
level.
“*Beyond VaR, then, we may also want to know how big
the loss will be when we have an exceedance event.
“¢ If an actual loss equals or exceeds the predicted VaR
threshold, that event is known as an exceedance.
¢* Another way to explain VaR is to say that for a one-day
95% VaR, the probability of an exceedance event on any
given day is 5%.
Expected Shortfall
“*If an actual loss equals or exceeds the predicted VaR threshold,
that event is known as an exceedance.
“A risk manager who measures one-day VaR at the 95%
confidence level will, on average, experience an exceedance event
every 20 days.
“A risk manager who measures VaR at the 99.9% confidence level
expects to see an exceedance only once every 1,000 days.
“It is tempting to believe that the risk manager using the 99.9%
confidence level is concerned with more serious, riskier outcomes,
and is therefore doing a better job.
“* The problem is that, as we go further and further out into the tail
of the distribution, we become less and less certain of the shape of
the distribution.
“* Beyond VaR, then, we may also want to know how big the loss
will be when we have an exceedance event.
Expected Shortfall
“*Using the concept of conditional probability, we can define the
expected value of a loss, given an exceedance, as:
“* ELL|L = VaRy| = ES, Wherein value at risk is defined as: P[L =
VaRy] = 1-X.
“*We refer to this conditional expected loss, S, as the expected
shortfall.
“* The use of the term expected shortfall is not universal.
**Many practitioners refer to this statistic as conditional VaR
(cVaR).
«+ If the expected profit of a fund can be described by a probability
density function given by f(y), and VaR is the VaR at the X
confidence level, we can find the expected shortfall as:
’ 1 VaR
% ES=—J_., yf v)dy
Expected Shortfall
“*If the expected profit of a fund can be described by a probability
density function given by f(x), and VaR is the VaR at the X
confidence level, we can find the expected shortfall as:
. 1 VaR
SES =— J, vf (dy
“* Example: The probability density function (PDF) for daily
profits at Pyramid Asset Management can be described by the
following functions:
% p=24+ce for -10<2<0
1 1 °
. P= 1407 100” forO0<az<10

+*

12 10 8 6 -4 -2 0 2 4 6 8 140 12

** The density function is zero for all other values of x. What is the
one-day 95% VaR for Pyramid Asset Management? For the same
confidence level and time horizon, what is the expected shortfall?
ES-Computational Procedures
¢ Example : The probability density function (PDF) for daily
profits at Pyramid Asset Management can be described by
the following functions:
1 1
= 76 + 7997 for -10<2z<0O

1 1
e p= 10 100” forO<z<10

¢ The density function is zero for all other values of Tl. What j is
the one-day 95% VaR for Pyramid Asset Management?
° Answer: To find the 95% VaR, we need to find a, such that
a

0.05 = / pdx
-10

By inspection, half the distribution is below zero, so we need only bother with the
first half of the function,

0.05 =“alae )

a a "|
ES-Computational Procedures
¢ Example: For the same confidence level and time horizon,
what is the expected shortfall?
¢ Answer: Because the VaR occurs in the region where z < O,
we need to utilize only the first half of the function.
¢ Using the above Equation S = — pes yf (y)dy, we have
VaR
1
S= xpd
0.05
-10

--20 [+ (70* vo")*

-10

“bea |
1 VaR
—_|_,2._
!' 23

0.00

-12
c T

-10
T

-8 -6
T

+4
T

-2
T

0
T

2
T

=
T

6
T

8
T

10
1

12
= 10-£v10
x
= 7.89
ES-Computational Procedures
“* Example : For the same confidence level and time horizon,
what is the expected shortfall?
“* Answer: Because the VaR occurs in the region where z < 0,
we need to utilize only the first half of the function.
“*Using the above Equation ES = — pes yf (y)dy, we have,
thus, the expected shortfall is a loss of 7.89.
“* Intuitively this should seem reasonable.
“*The expected shortfall > VaR(=6.84), but < the max. loss of 10.
“*Because extreme events are less likely in this example(the
height of the PDF decreases away from the center), it also
makes sense that the expected shortfall is closer to the VaR
than it is to the maximum loss.
Expected Shortfall when Portfolio Values are
Normally Distributed
“*If the expected profit of a fund can be described by a probability
density function given by f(y), and VaR is the VaR at the X
confidence level, we can find the expected shortfall as:
SES = — fi" yf dy
VaR

“e However, when the losses(gains) in the portfolio value are

normally distributed with mean p and standard deviation o,
“* VaR =ut+oY
e-¥ /2

vES =u+o—=—
V2m(1-X)
“* Here, X is the confidence level and Y = N~!(X) where N ( .) is the
inverse cumulative normal distribution.
“where Y is the X" percentile point of the standard normal distribution (i.e., it is
the point on a normal distribution with mean zero and standard deviation one
that has a probability 1 —- X of being exceeded).
“* Note: when u is assumed to be zero, ES, like VaR, is proportional to o.
Expected Shortfall when Portfolio Values
are Normally Distributed
“* When the losses(gains) in the portfolio value are normally
distributed with mean u and standard deviation o,
“ VaR=put+oY
vhs
weES = LU + ° an(1—X)

“* Here, X is the confidence level and Y = N~!(X) where N ( .) is the

inverse cumulative normal distribution.
“* Example : Suppose that the loss from a portfolio over a 10-day
time horizon is normal with a mean of zero and a standard
deviation of $20 million. The 10-day 99% VaR is:
“e 20*N (0.99) =2.326*20= 46.5 or $46.5 million(Since,
Cumulative probability: P(Z<2.326)=0.99
https://stattrek.com/online-calculator/normal.aspx).
Expected Shortfall when Portfolio Values are Normally
Distributed
“* When the losses(gains) in the portfolio value are normally
distributed with mean yu and standard deviation o,
% VaR =putoY
e-Y /2
eES =uto
V2m(1-X)
“+ Here, X is the confidence level and Y = N~!(X) where N () is the
inverse cumulative normal distribution.
** Example : Suppose that the loss from a portfolio over a 10-day time horizon is
normal with a mean of,zero and a standard deviation of $20 million. The 10-
day 99% VaR is: 20*N (0.99) =2.326*20= 46.5 or $46.5 million.
“¢¢ What about ES?
“* Because 2.326 is the point on a standard normal distribution that has a 1%
chance of being exceeded, the 10-day 99% ES is:
*° 9 =533 OF 3
$ . mil l ion .
V 2x x 0.01
Expected Shortfall Vs. VaR
* As with VaR, risk managers tend to talk about expected
shortfall in terms of losses.
“* Expected shortfall does answer an important question.
“*What’s more, it turns out to be subadditive, thereby
avoiding one of the major criticisms of VaR.
“eAs risk managers, we want to know as much about the
tail of the distribution as possible.
“¢ Expected shortfall tells us something about the tail.
“*VaR does not tell us anything about the shape of the
tail, but it is more robust to outliers. Whereas, ES is not.
“As risk managers, it is important to understand these
tradeoffs.
Choice of Parameters for VaR and ES
** For VaR and ES, a user must choose two parameters: the time horizon and the
confidence level.
** When the loss in the portfolio value has a mean of u and a standard deviation of o,
“ VaR =u+oY
e _y*/ 2
“ES =uto
V2nm(1-X)
“+ Here, X is the confidence level and Y = N~'(X) where N (.) is the inverse cumulative
normal distribution.

“- The Time Horizon:

“* An appropriate choice for the time horizon, when VaR or ES is
calculated, depends on the application.
“* When positions are very liquid and actively traded, it makes sense
to use a short time horizon (perhaps only a few days).
“On the other hand, when VaR or ES is being calculated by the
manager for portfolios like a pension fund, a longer time horizon
is likely to be used.
Choice of Parameters for VaR and ES
**The Time Horizon:
“* An appropriate choice for the time horizon, when VaR or ES is calculated,
depends on the application.
“* Thus, when market risks are being considered, analysts often start by
calculating VaR or ES for a time horizon of one day.
“*The usual assumption is, if losses in successive days are independent, normally
distributed, and have a mean of zero, then:
“*T-day VaR =1-day VaR x /T
T-day ES = 1-day ESx VT
“* The formulas follow from the earlier VaR & ES equations: VaR =w+oY
-y*/2
e
ES = »+o0—__
‘¢¢and the following results. v2m(1 — X)
>» The standard deviation of the sum on T independent identical distributions is
V T times the standard deviation of each distribution.
> The sum of the independent normal distributions is normal.
Choice of Parameters for VaR and ES
**The Time Horizon:
“*The usual assumption is, ff losses in successive days are independent, normally
distributed, and have a mean of zero, then:
“1 -day VaR =1-day VaR xJ/T
T-day ES = 1-day ESx JT
“* The formulas follow from the earlier VaR & ES equations: VaR =putoY
e-¥ [2
ES=utoa
V2n(1 — X)
**Example: Suppose that the change in the value of a portfolio over a one-day
time period is normal with a mean of zero and a standard deviation of $2
million; what is (a) the one-day 95% VaR, (b) the five-day 95% VaR, and (c) the
five-day 97.5% VaR? Note: Cumulative probability:P(Z<1.645)=0.95 &
P(Z<1.96)=0.975
“ Answer: (a) 2 x 1.645 = $3.29 million, (b) V 5 x 2 x 1.645= $7.36 million, (c) V
5 X 2 x 1.96 = 8.77 million.
Choice of Parameters for VaR and ES
“*Impact of Autocorrelation:
“*In practice, the changes in the value of a portfolio from one day to the next are
not always totally independent.
“* Define AP; as the change in the value of a portfolio on day i.
“eA simple assumption is first-order autocorrelation where the correlation
between AP; and AP,_, is p for all i.
“* Suppose that the variance of AP; is a7 for alli.
“*Using the usual formula for the variance of the sum of two variables, the
variance of AP;_4 + AP; is: o*+ a” +2p07 =2(1 +p)o* (same as Var(X+¥Y)=Var(X)+Var(Y)+2Cov(X,Y)).

“This implies, for T=1, then SD is:o,/T + 2(T — 1)p. For p = 0, SD will be:oVT
“* Similarly, the correlation between AP;_; and AP; is p/.
«* If there is autocorrelation p between the losses (gains) on successive days, the
standard deviation of the change in the portfolio value over T days )17_, AP; as:
% o/T + 2(T — Dp + 2(T — 2)p2 + 2(T — 3)p2 +. +2p7 ¥
Choice of Parameters for VaR and ES
“*Impact of Autocorrelation:
“*In practice, the changes in the value of a portfolio from one day to the next are
not always totally independent.
“*If there is autocorrelation p between the losses (gains) on successive days, the
standard deviation of the change in the portfolio value over T days )17_, AP; as:
% o/T + 2(T —1)p + 2(T — 2)p? + 2(T — 3)p3 ++. 4+2p7~ ¥
“¢ Table: Ratio of T-Day VaR CES) to One-Day VaR (ES) for Different Values of T When There Is
First-Order Correlation (and Daily Changes Have Identical Normal Distributions with Mean Zero).
+
+¢

T=1 |T=2 |T=5 |T=10 T=50 |T=250

p=0 1.0 1.41 2.24 3.16 7.07 15.81

p=0.05 | 1.45 2.33 3-31 7-43 16.62

p=0.1 1.0 1.48 2.42 3.46 7.80 17.47

p=02 |t° 1.55 2.62 3-79 8.62 19.35

Choice of Parameters for VaR and ES
“*Impact of Autocorrelation:
“*If there is autocorrelation p between the losses (gains) on successive days, the
standard deviation of the change in the portfolio value over T days )17_,, AP; as:
% o/T + 2(T — 1p + 2(T — 2)p? + 2(7 — 3)p2 ++. +297 ¥
“* Example: Suppose that daily changes in a portfolio value are normally distributed
with mean zero and standard deviation $3 million. The first-order autocorrelation of
daily changes is 0.1. Find five-day 95% VaR and ES value.
** From the above equation, the standard deviation of the change in the portfolio value
over five days is:
+ = - —
% 3/542K4xK0142x3x01242x2x
0.1342 1x O14 = 7.265

“* The five-day 95% VaR is therefore: 7.265 x N (0.95) = 11.95 or $11.95 million.
The five-day ES is: 54... 8? _ syog
2a x 0.05

“+ Note: the ratio of the five-day standard deviation of portfolio changes to the one-day
standard deviation is 7.2658 = 2.42(This is the number we found in the previous table
for p = 0.1 and T = 5).
Choice of Parameters for VaR and ES
“Confidence Level:
“*Regulators have used 99% for market risk and 99.9% for credit/operational
risk.
“*For example, a bank that wants to maintain an AA credit rating might use
confidence levels as high as 99.97% for internal calculations.
“*The confidence level that is actually used for the first VaR or ES calculation is
sometimes much less than the one that is required.
“*This is because it is very difficult to estimate a VaR directly when the
confidence level is very high.
“*A general approach for increasing the confidence level is extreme value theory,
which we shall be discussing later.
“*If daily portfolio changes are assumed to be normally distributed with zero
mean, we can use VaR & ES equations: VaR = oY
ey?2/,
ES
~ ” V2n(1 —X)
“To convert a VaR or ES calculated with one confidence level to that with
another confidence level.
Choice of Parameters for VaR and ES
“Confidence Level:
‘*If daily portfolio changes are assumed to be normally distributed with zero
mean, we can use VaR equation as:
** VaR(X) = oY = N71(X) for all confidence levels X.
¢+It follows that a VaR with a confidence level of X* can be calculated from a VaR
with a lower confidence level of X using
N~1(X*)
“Var(X -) = VaR(X). wing
“¢ Similarly, If daily portfolio changes are assumed to be normally distributed with
zero mean, we can use ES equation as:
ey /2
“ ES(X) =a
V2m(1-X)
“It follows that a ES with a confidence level of X* can be calculated from a VaR
with a lower confidence level of X using
(1-x)e" FP" -YY"+¥)/2
SES(X ) = ES(X).
(=x)
Choice of Parameters for VaR and ES
«Confidence Level:
“*It follows that a VaR with a confidence level of X* can be calculated from a VaR
with a lower confidence level of X using
N~1(X*)
“Var(X ) = VaR(X).
N~1(X)
“* Similarly, If daily portfolio changes are assumed to be normally distributed with
zero mean, we can use ES equation as:

SES(X ') = ES(X).

(1-X"*)
“* Example: Suppose that the one-day VaR with a confidence level of 95% is $1.5
million and the one-day expected shortfall is $2 million. Compute, VaR & ES with a
confidence level of 99%. ote: Cumulative probability:P(Z<1.645)=0.95 & Cumulative probability:P(Z<2.326)=0.99)

** Answer: Using the assumption that the distribution of changes in the portfolio
value is normal with mean zero, gives the one-day 99% VaR as: j5x a = 2.12
“*or, $2.12 million.
** Similarly, one-day 99% ES as: 2x ope OIE AS IIE 6852 =258 or, $2.58 million.
Marginal, Incremental, and Component
Measures for VaR (and ES)
“Consider a portfolio that is composed of a number of
subportfolios.
“* The subportfolios could correspond to asset classes (e.g.,
domestic equities, foreign equities, fixed income, and derivatives).
“*They could correspond to the different business units (e.g., retail
banking, investment banking, and proprietary trading).
“+ Analysts sometimes calculate measures of the contribution of each
subportfolio to VaR or ES.
“*Marginal VaR is the rate of change of VaR with the amount
invested in the ith asset.
“* Incremental VaR is the incremental effect of the ith asset on VaR
(i.e., the difference between VaR with and without the asset).
“*Component VaR is the part of VaR that can be attributed the ith
asset (the sum of component VaRs equals the total VaR).
Marginal, Incremental, and Component
Measures for VaR (and ES)
¢*Suppose that the amount invested in i” subportfolio is Z,.
¢*The marginal value at risk (mVaR) for the i“ subportfolio is the
sensitivity of VaR to the amount invested in the i* subportfolio.
OVaR
mVakR=
OZ;

“* To estimate marginal VaR, we can increase Z,; to Z,+AZ, for a

small AZ; and recalculate VaR. If AVaR is the increase in VaR, the
estimate of marginal VaR is AVaRAZ..
“* For a well-diversified investment portfolio, mVaR is closely
related to the capital asset pricing model(CAPM)’s beta.
“* If an asset’s beta ts high, its mVaR will tend to be high.
“If its beta is low, the mVaR tends to be low.
“*In some circumstances, mVaR is negative indicating that
increasing the weighting of a particular subportfolio reduces the
risk of the portfolio.
Marginal, Incremental, and Component
Measures for VaR (and ES)
“*The incremental value at risk(iVaR) for the ith subportfolio is the
incremental effect of the ith subportfolio on VaR.
“*1VaR=VaR with the subportfolio- VaR without the subportfolio.
*“¢ Traders are often interested in the incremental VaR for a new
trade.
“*The component value at risk(cVaR) for the ith subportfolio is:
4-7 —_OVaR, _ AVaR
6 Ci 7 OZ; Zi ~ AZ; Zi

“* It can be calculated by making a small percentage change y; =

AZ, /Z; in the amount invested in the ith subportfolio and
recalculating VaR.
Marginal, Incremental, and Component
Measures for VaR (and ES)
“The component value at risk(cVakR) for the ith subportfolio is:
OVaR AVaR
AZ;

“If AVaR is the increase in VaR, the estimate of cVaR= ~—

“*In many situations, cVaR is a reasonable approximation to
incremental VaR.
«*The total VaR is the sum of the cVaRs (Euler’s theorem).
“* The cVaR therefore provides a sensible way of allocating VaR to
different activities.
“*Marginal ES, incremental ES, and component ES can be defined
similarly to mVaR, iVaR, and cVaR, respectively.
Aggregating VaRs and ESs
¢*An approximate approach that seems to works well is where Vak;
is the VaR for the it* segment, VaR; is the VaR for the j'® segment,
VaR oq; 18 the total VaR, and p;; is the coefficient of correlation
between losses from the i' and j'" segments.
“*We can calculate the Vak,,,,,; of two linear positions using the
following formula:
“VaRrotal = /VaR*, +VaR?, + 2p;; VaRVaR,
“This is exactly true when the losses (gains) have zero-mean
normal distributions and provides a good approximation in many
other situations.
“*The same is true when VaR is replaced by ES.
“*Example: Suppose the ESs calculated for two segments of a
business are $60 million and $100 million. The correlation
between the losses is estimated as 0.4.
«+An estimate of the total ES is: v0? + 100? +2x 60x 100x 04 = 135.6
Backtesting Value at Risk (VaR)
“*Any risk model should be checked for consistency with
reality.
“*So far we have discussed how VaR is calculated using
various methodologies.
“*How accurate are these models?.
“*Backtesting 1s a process to compare systematically the
VaR forecasts with actual returns.
“*In other words, Back testing helps us test the accuracy
of a VaR model.
“*Under this technique, the losses forecasted using VaR
are compared with the actual losses at the end of the
time horizon(such as 1-day, 10-days, 1-month or more).
Backtesting Value at Risk (VaR)
** Days when the actual loss exceeds VaR are referred to as breaches/
exceptions/exceedances.
**Let’s say that we have the daily VaR figures at 99% confidence for
100 days. This means at 99% confidence, we can expect the losses
to breach the VaR on one out of 100 days.
“If exceptions happen on about 1% of the days, we can feel
reasonably comfortable with the current methodology for
calculating VaR.
“*If they happen on, say, 7% of days, the methodology is suspect and
it is likely that VaR is underestimated.
“*From a regulatory perspective, the capital calculated using the
current VaR estimation procedure is then too low.
“On the other hand, if exceptions happen on, say, 0.3% of days, it is
likely that the current procedure is overestimating VaR and the
capital calculated is too high.
Backtesting Value at Risk (VaR)
“* How to go about for backtesting & how to decide whether
to reject the model?
“*Suppose that the confidence level for a one-day VaR is
X%.
“*If the VaR model used is accurate, the probability of the
VaR being exceeded on any given day is p = 1 — XAOo.
“* Suppose that we look at a total of n days and we observe
that the VaR level is exceeded on k of the days where kn
> p.
“*We can consider two alternative hypotheses:
>The probability of an exception on any given day is p.
>The probability of an exception on any given day is
greater than p.
Backtesting Value at Risk (VaR)
“*When assessing a VaR model, each period can be viewed
as a Bernoulli trial.
“¢Either we observe an exceedance or we do not.
“*In the case of one-day 95% VaR, there is a 5% chance of
an exceedance event each day, and a 95% chance that
there is no exceedance.
“*In general, for a confidence level (1 — p), the probability
of observing an exceedance is p.
“* If exceedance events are independent, then over the
course of n days the distribution of exceedances will
follow a binomial distribution.
Backtesting Value at Risk (VaR)
“Therefore, given the theoretical probability of an
exception is p (= 1 — X/100). From the properties of the
binomial distribution, the probability of the VaR level
being exceeded on m or more days is:
a n! a
. F(k)= p(K=K)= FP Pd « k=0,1,...,n

“* Here, n is the number of periods that we are using in

our backtest, k is the number of exceedances, and (1 — p)
is our confidence level.
“* Here, the number of possible combinations of k
exceedances over n days is: Wl nl
k} kWn—k)!
Backtesting Value at Risk (VaR)
“*From the properties of the binomial distribution, the
probability of the VaR level being exceeded on m or more
days ts:
“* f(k) = p(K =k)= cn OI o‘(1— p)"*, k=0,1,...,n

“* Example: for one-day 90% VaR, there are three

possible outcomes over two days: There will be either 0, 1,
or 2 exceedances.
+ 2 On an2-0 2! 2
+,° rie =o1=(¢ ox 0.90° = Dr * 1 x 0-90 = 0.81

!
PIK =1]= (;) 0.10'0,.902-! = oS x 0.10 x 0.90 = 0.18

2 5 = ! 5
= 2+902-
PK =2]=( ~ )0.1020. 2 1 =0.01
x 0.10?x
2 210!
Backtesting Value at Risk (VaR)
“*From the properties of the binomial distribution, the
probability of the VaR level being exceeded on m or more
days ts:
n!
“ £(k)(kK) == p(K
p( =k) ) = K(n-K!P K1—p)"*,
(1— p) k=0,1,...,n

“* Example: As a risk manager, you are tasked with

calculating a daily 95% VaR statistic for a large fixed-
income portfolio. Over the past 100 days, there have been
four exceedances.(a)How many exceedances should you
have expected?(b) What was the probability of exactly
four exceedances during this time?(c) What was the
probability of four or less? (d)Four or more?(e)Should
you reject the model?
Backtesting Value at Risk (VaR)
“*The probability of the VaR level being exceeded on m or more days is:
oe _ _ _ n! kK q n-k _
eEK= PKK) =F iP (1- p)"", k=0,1,...,n

“+ Example: As a risk manager, you are tasked with calculating a daily 95% VaR
statistic for a large fixed-income portfolio. Over the past 100 days, there have
been four exceedances. (a)How many exceedances should you have expected?(b)
What was the probability of exactly four exceedances during this time?(c) What
was the probability of four or less? (d)Four or more?(e)Should you reject the
model?
“+ Answer: Remember, by convention, for a 95% VaR the probability of an
exceedance is 5%, not 95%. Over 100 days, then, we would expect to see five
exceedances: (1 — 95%) x I 100 = 5. The probability of exactly four exceedances is
17.81%. f (4) = p(K =4)= srggi oo 0-95)", k=4=0.1781
we 100
° F(<4)=p(K<4)=>™ . 0.05*(0.95)'°*, k=0,1,...,4=0.4360

¢* The probability of four or fewer exceedances is 43.60%. Here, we simply do the

same calculation as before, but for zero, one, two, three, and four exceedances.
“It’s important not to forget zero:
Backtesting Value at Risk (VaR)
“*The probability of the VaR level being exceeded on m or more days is:

* £(k)= p(K “=a pi Ph p)"*, k=0,1,....n

“+ Example: As a risk manager, you are tasked with calculating a daily 95% VaR
statistic for a large fixed-income portfolio. Over the past 100 days, there have
been four exceedances. .(a)How many exceedances should you have expected?(b)
What was the probability of exactly four exceedances during this time?(c) What
was the probability of four or less? (d)Four or more?(e)Should you reject the
model?
f(4)=p(K =4)= 100!
+ * Answer: 0.054(0.95)*, k=4=0.1781
+

4196!
S

100
+¢
>

we f(<4)=p(K<4)= ith Joos (0.95)'""*, k=0,1,...,4=0.4360

+

¢*For the final result, we can calculate the probabilities for k = 4, 5, 6, ..., 99, 100, a
total of 97 calculations. Instead, we realize that the sum of all probabilities from
O to 100 exceedances must be 100%. Therefore, if the probability of K < 4 is
43.60%, then the probability ofK > 4 must be 100% — 43.60% = 56.40%.
“* Be careful, though, we want the probability for K = 4.
Backtesting Value at Risk (VaR)
“*The probability of the VaR level being exceeded on m or more days is:

* £(k)= p(K “=a pi Ph p)"*, k=0,1,....n

“+ Example: As a risk manager, you are tasked with calculating a daily 95% VaR
statistic for a large fixed-income portfolio. Over the past 100 days, there have
been four exceedances. (a)How many exceedances should you have expected?(b)
What was the probability of exactly four exceedances during this time?(c) What
was the probability of four or less?(d)Four or more?(e)Should you reject the
model?
** Answer: For the final result, we simply add the probability that K = 4 to our
previous answer to get the final answer, 74.21%, P[K = 4] = P[K > 4] + P[K=4]
“> PIK = 4] = 0.5640 + #40.1781 = £0.7421(in Excel =1-
BINOMDIST(3,100,0.05, TRUE)=0.7421).
“+ In this case, even though we would have expected to see five exceedances, the
probability of four or more exceedances or four or less exceedance is very high,
43.60% and 74.21%, respectively.
«+ Based on these results, we would be unlikely to reject our VaR model
Backtesting Value at Risk (VaR)
“* The probability of the VaR level being exceeded on m or
more days Is:
\ n
+,°
n! k n-k
d K(n—k)!? U—P)
“* Example: Suppose that we back-test a VaR model
using 600 days of data. The VaR confidence level is 99%
and we observe nine exceptions. The expected number of
exceptions 1s six. Should we reject the model?
“* Answer: The probability of nine or more exceptions can
be calculated AS> (in Excel, 1- BINOMDIST(8,600,0.01,TRUE)=1-0.848=0.152).

“*At a 5% significance level we should not therefore reject

the model.
Backtesting Value at Risk (VaR)
“* The probability of the VaR level being exceeded on m or
more days Is:
\/ n
+,°
n! k n-k
2 K(n—k)!? U—P)
“* Example: Suppose that we back-test a VaR model
using 600 days of data. The VaR confidence level is 99%
and we observe nine exceptions. The expected number of
exceptions is six. Should we reject the model?
“* Answer: The probability of nine or more exceptions can
be calculated AS> (in Excel, 1- BINOMDIST(8,600,0.01,TRUE)=1-0.848=0.152).

“*At a 5% significance level we should not therefore reject

the model.
Backtesting Value at Risk (VaR)
“*The probability of the VaR level being exceeded on m or more days is:
% 0 n!
nk k (4 n—-k

xmnewi? OOP)
«* Example: Suppose that we back-test a VaR model using 600 days of data. The
VaR confidence level is 99% and we observe nine exceptions. The expected
number of exceptions is six. Should we reject the model?

«* Answer: However, if the number of exceptions had been 12 we

would have calculated the probability of 12 or more exceptions as
0.019(1-BINOMDIST(11,600,0.01, TRUE):1-0.981=0.019) and
rejected the model.
“*The model is rejected when the number of exceptions is 11 or
more.
“*The probability of 10 or more exceptions is greater than 5%, but
the probability of 11 or more is less than 5%.
Backtesting Value at Risk (VaR)
“On the other hand, when the number of exceptions, m, is lower
than the expected number of exceptions, we can similarly test
whether the true probability of an exception is 1%. (In this case, our
H,is that the true probability of an exception is less than 1%.)
“* The probability of m or fewer exceptions ts:
~ n! k n-k
army C~P)
“* Example: Suppose that we back-test a VaR model using 1,000
days of data. The VaR confidence level is 99% and we observe 17
exceptions. Should we reject the model at the 5% confidence level?
Use a one-tailed test.
¢¢ Answer: The probability of 17 or more exceptions is 1-
BINOMDIST(16,1000,0.01, TRUE) or 2.64%(1-
BINOMDIST(16,1000,0.01, TRUE)=1-0.974=0.0264). The model should be
rejected at the 5% confidence level.
 innovate achieve

Thank You!!!

BITS Pilani, K K Birla Goa Campus