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Summary Risk Management

Risk Management (Technische Universiteit Delft)

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Summary Risk Management

Lessons 1&2

= −
= 0.40 ∗ 0.05 + 0.10 ∗ 0.55 − 0.05 ∗ 0.30 − 0.10 ∗ 0.10 +40%
Standard Deviation: Yearly Return Probability

= 0.05
0.05

= 0.40 ∗ 0.05 + 0.10 ∗ 0.055 + 0.05 ∗ 0.30

+10% 0.55

+ −0.10 ∗ 0.10 = 0.01525

-5% 0.30

= 0.01525 − 0.05 = 0.1129

-10% 0.10
Higher Standard Deviation -> higher Volatility->Higher Riks of Investment

Lessons 3&4

We consider 2 Investment with Returns R1 en R2. We put a proportion w1 of our money

= ! " #$ $%:
in R1 and w2 for R2

= '( ( + ' = '( ( +'

The expected return

= '( ( + '
And the standard deviation ) is given by:

) = *'( )( + ' ) + +(, '( ' )( )

Any new investment can be combined with the
existing ones. If we consider all the possible risky
investments on the market, we can obtain the
well-known Efficient Frontier(EF). The EF
represents the set of all the portfolios that
maximize the expected return and minimize the
standard deviation, thus dominating all the other
portfolios. The portfolios on the EF are convex
linear combinations of all the portfolios of the
economy

The line from F to M is te line that represents the

portfolio I by investing a proportion -. of our funds in the risky market portfolioM and
new efficient frontier. Imagine that we create a

1 − -. in the risk-free investment F: The expected return of this portfolio is:

. = 1 − -. / + -. 0
And its standard deviation is: ). = -. )1
All the points on the segment FM can be obtained as convex combinations of investments
F and M. These points dominate the previous frontier (better risk-return combination)

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Assume that we can borrow at the risk-free rate of 2 and that we can invest at that rate
too. Let’s borrow a quantity -3 − 1 of the funds we can invest at rate 2 and let’s put
everything (our initial funds and the borrowed funds) in portfolio M.

3 = -3 0 − 4-3 − 15 / 678)3 = -3 )1
We obtain a now portfolio J with expected return:

When a risk-free investmenst is present on the market, the efficient frontier is a straight
line. Portfolio M is defined as the market portfolio and is necessarily contains all risky

investments (RI)

. = 1 − -. / + -.
Capital Asset Pricing Model (CAPM)
0 . Removing expectation and setting
1 − -. / = 6 : . = 6 + -. 0 +9
We know:

-. 0
9 = non-sysematic or idyosincratic risk (IR)
= Systematic risk (SR)

We can re-arranging . = 1 − -. / + -. 0 to:

You are portfolio manager and your portfolio has a beta of 0.75.
The one-year riks-free rate 3% and the return on the market during the year is 5%.

: = ;− 2 −- 1− 2
Your return as portfolio manger is 8.5%, (higher than the market). What is your alpha?

: = 0.085 − 0.03 − 0.75 0.05 − 0.03 = 0.04

Types of banks:
Central bank: Public institution that manges the money of supply of a monetary
union/nation under a regime of monopoly. It acts as an intermediary for other banks and
often represents the lender of last resort. It monitors the national banking sector

Commercial Bank: It lends money and provides payment, savings, and money accounts.
It accepts deposits and collects capitals. We can have retail banking and wholesale
banking.

Investment Bank: A financial institution that halps its customers in raising and investing
capitals and trading. It often provides ancillary services such as business consuling,
market making and new financial products development.

!> = > − ?
Lessons 5&6

!> = ? − >
Long position
Short Position

@ AB = C N 81 − ?E F> N 82
Black Scholes formula:

L TU
HIJK M OPQR± V>
G AB
= ?E N 82 −
F>
CN 81 81,2 =
N U
W√>

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The Greeks:

An increase of €1 in the price of gold corresponds to a decrease of €800 in the value of

∆;
∆B
our portfolio. In general terms, the Delta of a portfolio is give by:

gains €800 per €1 increase in the price of gold. This is ∆-hedging

We can eliminate our delta exposure by buying 800 ounces of gold. In fact, our position

Lambda (also known as elasticity) gives the percentage change in portfolio value per

[G
percentage change in the underlying price:
λ= ∗
[ G
and it is clearly linked to delta: λ = ∆ ∗
B
;

Gamma tells us to which extent large changes cause problems.

Γ=
]U;
]B U

If the price of a stock moves from S to S’. According

to delta hedging and linearity, we expect the value of
the corresponding call to move from C to C’.
However, because of nolinearity, the tru value of the

C’’-C’ is the ∆ hedge-error.

call is C’’.

We have a Delta-neutral portfolio with Γ = 2000

The Delta and the Gamma are 0.7 and 2
The Portfolio can be Gamma-neutral by writing a position of -2000/2=-1000 in the option
However, the Delta of the new portfolio is now 0-1000*0.7=-700. We than need to buy a
quantity 700 of the underlying asset to make the portfolio Delta-neutral.

The Vega of a portfolio is the partial derivative of the value of the portfolio with respect

[G
to the volatility of the underlying asset:
^=
[)
The higher the Vega, the more sensitive is the portfolio to small changes in volatility.

How can we made the portfolio both gamma Delta Gamma Vega

Let '( 678 ' be the quantities we can add:

and vega neutral? Portfolio 0 -3000 -5000

−3000 + 0.5'( + 0.8'

Option 1 0.6 0.5 2.0

−5000 + 2.0'( + 1.2'

Option 2 0.5 0.8 1.2

By solving we obtain: '( = 400 678 ' = 3500

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underlying asset to keep ∆-neutrality

The new Delta is now 400*0.6+3500*0.5=1990, and we have to sell 1990 units of the

Taylor series expansions:

Lessons 7&8

We have an amount X that we invest for n years at an interest rate of r per annum:
If it compounded once per annum: X(1+r)n
If it compounded m times per annum: X(1+(r/m))m*n (frequency compounding) rc
Assume now that m tends to infinity: Xer*n (continuous compounding)rm

Forward rate is the future zero rate implied by today’s zero rates. (the interest rate of a
zero-coupon bond is said zero rate)

− ( (
The forward rate F for the period [T1,T2] with zero-rates r1 and r2:
_=
− (
The theoretical value of a bond is the discounted value of all the future cash flows
generated by the bond itself
Maturity (years) Zero rate rc
Example: 0.5 4.0
We expect six-month interest rates to be quite 1 4.8
stable for the next two years. 1.5 5.2
Imagine we have a bond with par value equal to 2 5.5
€100 that pays 5% per annum semiannually (coupon= €2.5)

2.5E `C.Ca∗C.b + 2.5E `C.Cac∗( + 2.5E `C.Cb ∗(.b + 102.5E `C.Cbb∗ = 98.97
If we use the zero-rates in the previous table we have:

price: 2.5E `d∗C.b + 2.5E `d∗( + 2.5E `d∗(.b + 102.5E `d∗ = 98.97
The yield of an investment is the discount rate that gives a bond price equal to its market

This gives y=0.05475

Net interest income is the excess of interest received (e.g. from loans) over interest paid
(e.g. on deposits)
Net interest margin(NIM) is then the ratio between net interest income and income pure
producing assets.

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€10 h$##$ 7 1 − iE6 %

Example:
e 67% f
€ 30 h$##$ 7 5 − iE6 %

35 h$##$ 7 1 − iE6 %
E! %"$% f
€5 h$##$ 7 5 − iE6 %
Equity= €2 billion R.O.E.= 12% 30% tax rate
What change in interest rates next year would cause the bank’s R.O.E. to be reduced to 0

The bank has an asset/liability mismatch of €25 billion

The profit after tax is currently 12% of €2 billion or €0.24 billion
If interest rates rise by x% the bank’s before-tax loss (in billions of euros) is
25*0.01*x=0.25x. After taxes this loss becomes 0.7*0.25x=0.175x
The banks R.O.E. would be reduced to zero when 0.175x=0.24, so that x = 1.37
A 1.37% rise in rates would reduce the R.O.E. tot 0

London interbank offered rate (LIBOR) is the rate at which a bank is prepared to lend
money to another bank.

1∆ = j6 kE" ! $lE
Duration represents the exposure of a portfolio to yield curve movements:
=−
∆i i = h 78 i$E#8
q
Consider the case of a bond generating cash flows c1, c2,..cn at times t1,t2,…,tn

= m ln E `dop
n`(
q
ln E `dop
7 − iE6 tE − l ! 7: = 7
= m "n r s f
7 − iE6 l ! 7 h 78: < 7
n`(
Example:
3 years coupon bond with a face value of €100. Continous compounding yield is y=0.12
per annum. 5% coupons are given every 6 months (€5) What is the Duration?

= 5 ∗ E `C.( ∗C.b + ⋯ . +105 ∗ E `C.( ∗w = 94.213

First compute the market price:

5 ∗ E `C.( ∗C.b 5 ∗ E `C.( ∗w

Then determine the Duration:
= 0.5 ∗ + ⋯+ 3 ∗ = 2.653
94.213 94.213
And D is smaller than 3, So that is good.

Assume now that the yield increase by 0.1%, this means that y*=y+0.001 (∆= 0.001

1∆
What is the variation in the bond value?
=− ⟹ ∆ = − ∆i
∆i
∆ = −2.653 ∗ 94.213 ∗ 0.001 = −0.250
∗
= 94.213 − 0.250 = 93.963

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We can check this by re-compute the bond value: 5 ∗ E `C.( (∗C.b

+ ⋯ . +105 ∗
E `C.( (∗w = 96.963

q
ln E `dop
If we substitute continuous compounding with frequency compounding(with m), we get:

= m "n r s ⟹ ∗ = i
n`( 1+j

it may remind the ∆ Greek. However, duration can be misleading in some cases. Two
Duration is a good measure to analyze exposure to small changes in yields. In some sense

bonds may have the same D, but they may re-act differently to large shocks in the yields.

Convexity relation:
This is why we may want to introduce a measure of convexity.

∆ 1
= − ∗ ∆i + ∗ @ ∗ ∆i
2
Examplje: Consider the same bond as we have seen before:

Imagine the yield change from 12% tot 14% (∆i = 0.02
S=94.213, y=0.12, D=2.653, and the convexity is easily computed to be C=7.57

∆ = − ∆i = −2.653 ∗ 94.213 ∗ 0.02 = −4.999

According to duration:

1
According to Convexity relation:
∆ = − ∗ ∆i + ∗ @ ∗ ∆i
2
∆ = 94.213 −2.653 ∗ 0.02 + 0.5 ∗ 7.57 ∗ 0.02 = −4.8563
The convexity guarantees better results
If the duration of a portfolio is 0, that guarantees the stability of its value in the case of
small changes in the yield curve. If we build a portfolio for which both the duration and
the convexity are 0, then the portfolio is immune to large shifts too.

Lessons 9&10

VaR is a measure of risk that tries to answer: “ How bad can things get?”
With probability α we will not lose more than V euros in time T

z6 {0|}q = z6 { −
Let be the mean of the loss distribution. The mean-VaR is defined as:

If the time horizon is 1 day, the mean-VaR is known as daily earnings at risk in market
risk assessment.(het verschil tussen VaR and mean-VaR is te verwaarlozen in market risk

z6 { = + ) ∗ ~ `( : z6 {0|}q = ) ∗ ~ `( :
management, helemaal bij korte tijdhorizons)

Example:
The historical 1-month loss distribution of a portfolio in € million is well approximated

~ `( 0.95 = 1.6448, 678 ~ `( 0.98 = 2.0537

by a N(10,5) What is the 95% VaR and the 98% VaR?

⟹ z6 C.•b e = 10 + 5 ∗ 1.6448 = 18.2243

z6 C.•c e = 10 + 5 ∗ 2.0537 = 20.2687

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Expected shortfall, conditional value at risk: “If things go bad, what is the expected
loss?”

Example: A financial decision may lead to following losses:

What is the Expected Shortfall for α=0.95 and α=0.99?

12 ∗ 0.02 + 20 ∗ 0.025 + 0.005 ∗ 25

= = 17.3
C.•b
0.05 Loss Probability
20 ∗ 0.005 + 25 ∗ 0.005
= = 22.5
1 40
C.••
0.01
2 35
5 8
Is the VaR coherent?
10 12%
12 2%
20 2.5%
25 0.5%

It is easy to show that VaR is not coherent, especially because it is not subadditive.

Example:
We have two independent investments. They both have a probability of 0.02 of a loss of
$10 million and a probability of 0.98 of a loss of $1 million over a 1-year time window.
The VaR(0.975) is $1 million for each investment.
Since the two investments are independent, there is 0.02*0.02=0.0004 probability of a
$20 million loss, 2*0.02*0.98=0.0392 for a $11 million loss and 0.98*0.98=0.9604 for a

11 = z6 C.•€b •( + • > z6 C.•€b •( + z6 C.•€b • = 1 + 1 = 2

$2 million loss. In this case the VaR(0.975) is $11 million dollar.

The ES is not sub-additive and so also not coherent.

If changes in the value of the portfolio on successive days are independent normal

z6 { = z6 { √
>`ƒ}d (`ƒ}d
distributions with 0 mean, then the following formula can be applied:

> >
The assumption of time-independence is not harmless. In General:

„6 m ∆Gn = ) m $ − $ + 1 +n`(
n…( n…C
Example:

parameter 0.12. The 10-day VaR, calculated by multiplying the one-day VaR √10 is €2
Suppose that daily changes for a portfolio have first-order correlation with correlation

million. What is a better estimate of the VaR that takes account of autocorrelation?

10 + 2 ∗ 9 ∗ 0.12 + 2 ∗ 8 ∗ 0.12 + 2 ∗ 7 ∗ 0.12w +. . + 2 ∗ 0.12• = 10.417

The correct multiplier for the variance is:

The estimate of VaR shoud be increased to 2 ∗ = 2.229

√(C.a(€
√(C

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Back-testing is a validation procedure often used in risk management. Just checking the
historical data. We count the number of days in the past in which the actuall loss was
higher than our 99% VaR. If these days, called exceptions, are less than 1% then our
back-testing is successful. If exceptions are say 5%, then we are probably

If our z6 { is accurate, the probability p of observing an exceedance is 1- α.

underestimating actual VaR.

According to the binomial distribution, which tells us the probability of observing m

exceedances: ∑q̂…0 !ˆ 1 − ! q`ˆ

q!
“successes” in n “trials”, we have the probability that we observe more than m
ˆ! q`ˆ
Generally we chose a 5% significance level for the test. This means that, if the
probability of observing an exceedance is less than 5%, we reject the null hypothesis that
the exceedance probability is p. Otherwise we cannot reject the null hypothesis.

Example:
We want to back-test our VaR using 900 days of data. Α=0.99 and we observe 12
exceedances. According to our VaR we
expect only 9 exceedances. We cannot
reject the null hypothesis, cause
0.1231>0.05. If we have 20 exceedances,
we reject, cause 0.000406<0.05.

Banks that use the inernal model for MR essentially apply the following formula to
ŒC
k
determine regulatory capital:

@.1
o
‰ = j6Š ‹z6 C.•• ,
o,(C
m z6 o`nP(.(C
• + @BR
60 C.••
n…(
Factor 3 ≤ k ≤ 4 is called stress factor. @BR represents specific issuer risk after
accounting for general market factors.

Lesson 11

Volatility: The standard deviation of the returns provided by the variable of interest, per
unit of time under continuous compounding.
Calendar days: 365, Business days: 252 or 256

Example of volatility:
Asset price is €50 and its daily volatility is 1.5%
Since we are assuming that the daily changes are normally distributed, we can 95%

50 ± 1.96 50 ∗ 0.015
certain that the asset price will oscillate:

Under normally assumption, if x is a random variable with expected value 0, the ratio of
standard deviation to mean deviation should satisfy the following equality:
∑|Š| 2
=•
∑Š ‘

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This means that mean absolute deviation is about 0.8 times standard deviation.

)q is the volatility in day n, as estimated at the end of day n-1

The variance is defined as ) .

=
B’ `B’“”
If we define: q B’
0
1
)q = m
j q`(
n…(

variance rate z• and that this should be given some weight – as well, and this is the
The idea of weighting can be easily extended by assuming that there is some long-run

0 0
ARCH(m) model:

)q = –z• + m :n q`( , —ℎE E – + m :n = 1

n…( n…(
Notice that quite often: –z• = ' (ARCH models are generalized by GARCH)

)q = –z• + :n q`( + -)q`(

A GARCH(1,1) model is defined as:

Where all the weights sums to 1

Example:

' = 0.000002, : = 0.03, - = 0.95

Suppose that the correctly estimated parameters in a GARCH(1,1) model are:

Since : –z• = ' and – + : + - = 1 then

• What is the long-run average volatility?

' 0.000002
z• = = = 0.0001
1−:−- 0.02
The long-run average volatility is the square root of 0.0001 is 0.01 (1%)
• If the current volatility is 1.5% per day, what is your estimate of the volatility in
20 days and 60 days?

)qPo = z• + : + - o )q − z•
In the book is founded the next formula:

0.0001 + 0.98 C 0.015 − 0.0001 = 0.000183

Applying the formula, we have for t=20

And the square root of 0.000183 is 0.0135(=1.35%)

For t=60, the expected volatility is 1.17%
• Suppose that there is an event that increases the volatility from 1.5% per day tot

0.0001 + 0.98 C 0.02 − 0.0001 = 0.0003

2% per day. Estimate the effect on the volatility in 20 days.

So the expected volatility is the square root of 0.0003, is 1.73%

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Lessons 12&13

A Copula is a special type of distribution function which is used to describe the

dependence between two or more random variables.
The joint distribution of a random vector can be written in terms of marginal distribution
functions and a copula. The marginal describe the marginal distribution of each
component of the random vector, while the copula describes the dependence structure
among the components.

Basel II

Basel II(2004) was the 2nd of the Basel Accords(Basel I was in 1988, i.e.
recommandations on banking laws and regulations issued by the Basel Committee on
Banking Supervision (BCBS)

Basel II was meant to create an international standard for banking regulators to control
bank’s risk capital. i.e. the capital banks gather to protect themselves from the financial
and operational risks they may face.

One of the points was to guarantee sufficient consistency of regulations among nations in
order to avoid competitive inequality amongst internationally active banks (however
many countries were not in favor, e.g. USA)

Basel II attempted to reduce the risks of collapses in the banking sector by setting up risk
and capital management requirements designed to ensure that a bank had adequate capital
for “covering” the risks connected to the lending and investment activities
According to Basel II, the greater is the risk to which a bank exposed, the greater the
amount of capital that bank needs to hold to safeguard its solvency and overall economic
stability

After the 2008 crisis, Basel II has been integrated in the Basel III framework.

The main objectives of Basel II can be summarized as follows:

• To guarantee that capital allocation is more risk sensitive;

• To enhance disclosure requirements that allow market participants to assess the

capital adequacy of an institution;

• To ensure that market risk (B1), credit risk (B1-2) and operational risk (B2) are
quantified on the basis of data and formal techniques;

• To try to uniform economic and regulatory capital to reduce the space for
regulatory arbitrage and speculation.

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Basel II was build on a three-pillar construction:

Basel III

Basel III (2011) tries to overcome the limits of Basel II, by strengthening bank capital
requirements and introducing new regulatory requirements on bank liquidity and bank
leverage.

Many innovations about information transparency and capital requirements (general

increase). Introduction of a special surveillance for the leverage ratio of banks.

Many optional parts of Basel II are now mandatory, e.g. Downturn LGD and long time
horizons.

Towards a greater integration of risks, i.e. market and credit risks.

Critics suggest that greater regulation is responsible for the slow recovery from the 2008
financial crisis, and that the Basel III requirements will increase the incentives of banks
to game the regulatory framework, which could further negatively affect the stability of
the financial system.

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Lessons 14&15

Market Risk(MR): The risk of losses in on- and off-balance sheet positions arising from
movements in market prices. (Most important tools to asses and hedge MR: VaR and ES)
There are two main approaches to the assessment and the use of the loss distribution:
1. Historical-simulation Approach.
2. Model-Building Approach

Historical simulation involves the use of past data to make predictions about the future.
A typical approach in Market Risk is to use 501 days of data, because we can generate
500 different scenarios, as expected under the historical simulation approach;
The first day of data availability be Day 0, then second day is Day 1…. Scenario 1 is
percentage change between day 0 and day 1. Scenario 2, between Day 1 and Day 2, So
we get 500 scenarios.

The first step is the identification of market variables who affect the value of the portfolio

™n
Value under i-th scenario:
™qP( = ™q
™n`(
Today is day n, ™ is the value of a market variable on day i.

Banks are required to provide an additional measure of risk: Stressed VaR

The S-VaR is the VaR on the worst scenarios, typically the worst half of the scenarios.

The VaR computed under historical simulation clearly depends on a finite number of
observations. This may leed to errors in estimation. (Accuracy) A solution is to provide a
confidence interval for the VaR. The standard deviation of the α-percentile x is:
1 1−: ∗:
= • , Š $% "ℎE %"6786 8 8$%" $h "$ 7 "ℎE z6
Š 7

z6 C.•• = 25 , using a historical simulation with n=500. Standard Distribution for the
Example:
(

VaR is a N(0,10) What is the 95% confidence interval?

1 1−: ∗: 1 0.01 ∗ 0.99
= • = • = 1.67
Š 7 0.0027 500
1 1
=
Š š ›
Q= qnorm(0.99,0,10) and š › = 87 j ›, 0,10
The confidence interval is: 25 ± 1.67 ∗ 1.96

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In periode of high and oscillating volatility, it can be useful to incorporate such

„n`( + „n − „n`( )qP( /)n

information in the scenarios. A way of doing this is to use the Hull and White formula:

„qP( = „q
„n`(
Where )qP( is the current estimate of volatility for tomorrow, given today.

What if we do not have a sufficient number of observations?

• Under the historical-simulation approach, we can bootstrap the available data, in
order to create a larger sample.
• An alternative is to pass to the model-building approach

Given the VaR, the Basel Agreements require the use of the following formula to

@ = max4z6 C.•• o`(

; j¡ ∗ z6 }¢£
ŒC
5 + max4%z6 C.••
o`(
; j¤ ∗ z6 }¢£
ŒC
5
determine the daily capital requirements of a bank:

z6 C.••
o`(
: e6%" jE6% E 6„6$#6h#E
j¡ : ‰ #"$!#$E ¥$„E7 hi "ℎE E¥ #6"
z6 }¢£
ŒC
: ¦„E 6¥E „E "ℎE #6%" 60 86i%

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Lessons 16&17

Extreme Value Theory (EVT) is an important branch of statistics, dealing with extreme
and rare events. It shows that the tails of a wide range of different probability
distributions share common properties. The EVT uses two main approaches to study
extremes:
1. Block-Maxima
2. Peaks-over-threshold

The Block-Maxima (BM) approach, observations are divided into blocks and, for each
block, only the maximum(or minimum) value is considered.

The Peaks-over-threshold (POT) method, a threshold u is defined, and only the

observations overcoming that threshold are taken into consideration. The distribution of
(
Š `¨
the rescaled maxima is the GPD:
-
«1 − Q1 + ® V , ® ≠ 0
§¨,© Š = -
¬ Š
« 1 − exp Q− V , ® = 0
ª -
Where - > 0 and Š ≥ 0 if ® ≥ 0, or 0 ≤ Š ≤ −
©
¨
The distribution has two parameters that have to be estimated from the data. These are ®

the distribution. The parameter - is a scale parameter. When the underlying variable v
and -. The parameter ® is the shape parameter and determines the heaviness of the tail of

has e normal distributin, ® = 0. As the tails of the distribution become heavier, the value
® increases.
The paramters ® 678 - can be estimated using Maximum Likelihood methods. We have
(
to maximize:
q¸
1 ® Šn −
` `(
¨
m log ¶ r1 + s ·
- -
n…(
We can do that numerically. (7¹ is the number of exceedances)

§̅¨,© Š = 1 − §¨,© Š
Studying the upper tail of the GPD is quite simple. We need to consider the survival
function:

(
7¹ Š − `¨
And then look for the exceedances v that are greater than x > u:

G h „>Š = »1 + ® ¼
7 -
= and : = ,
© (
¨ ¨
If we set
(
7¹ ®Š ¨
G h „>Š = Q V = ?Š `{
7 -
(
7¹ ® `¨
—ℎE E ? = » ¼
7 -

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The greatest probling in using the GPD to model maxima is the choice of the threshold u.
There are different methods available but, heuristically we can say:
• U should be greater then the 95% percentile of the empirical distribution
• U should be the value for which the emplot and the meplot show some sort of
linearity.
The theoretical approximation with the GPD makes sense because, in general, we have
just few empirical observations of extremely large losses.
Under Paretian tails, the VaR and the ES can be easily computed as:
`¨
- 7
z6 = + ½¾ 1−: ¿ − 1À
{
® 7¹
z6 +-−®
=
{
{
1−®

The model-building approach, also know as the VaR-Cov approach, is a simulation in

the assessment of MR (an alternative to historical simulation).

and standard deviation ): z6 { = ) ∗ ~ `( :

If we have a portfolio with only 1 single asset, and its normally distributed, with mean 0

When a portfolio consists of two assets say 1 and 2:

) = )( + ) = *)( + ) + +(, )( )
Example:
$10 million of Microsoft shares and $5 million of AT&T shares. The daily volatilities are

)1n¡FÁ = 0.02 ∗ 10.000.000 = 200.000

2% and 1% respectively. The correlation is 3. The standard deviations are:

)Â>&> = 0.01 ∗ 5.000.000 = 50.000

) = 200.000 + 50.000 + 2 ∗ 0.3 ∗ 200.000 ∗ 50.000 = 220.227

Standard deviation of the portfolio is:

The 95% VaR is: z6 C.•b = 1.6648 ∗ 220.227 = 362.241

If we take the two VaR of the two assets separately we get 411.213 (328.971+82.242).
The VaR we have computed is subadditive. The difference is 48.972; this is the impact of
diversification. It represents what we gain, in terms of reduction of risk, when we
diversify our portfolio.

Suppose that we have a portfolio worth P consisting of n assets with an amount :n being
invested in asset $ 1 ≤ $ ≤ 7 . Define the ∆Šn as the return on asset i in one day. The
dollar change in the value of our investment in asset i in one day is :n ∆Šn :
∆G = ∑qn…( :n ∆Šn
previous example: ∆G = 10∆Š( + 5∆Š
And:

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q q

); = m :n )n + 2 m m +n,Ä :n :Ä )n )Ä
n…( n…( ÄÅn

); = 10 ∗ 0.02 + 5 ∗ 0.01 + 2 ∗ 10 ∗ 5 ∗ 0.3 ∗ 0.02 ∗ 0.01

So for previous example:

l „nÄ = )n )Ä +nÄ
The covariance between variable i and variable j:

q q
So we can rewrite the previous formula:

); = m m l „ $, Æ :n :Ä
n…( Ä…(

and where Ç is the (column) vector whose i-th element is :n and Ç> is the transpose of Ç
Using the matrix representation, where C is the variance-covariance matrix of the returns,

); = Ç> @Ç

Duration approximation: ∆G = − G∆i

€8 million in bonds, Duration of our portfolio is 3.5 years, yield change of 0.04%.

3.5 ∗ 8.000.000 ∗ 0.0004 ∗ 1.6448 = 18422.36

1-Day 95% VaR for the portfolio: Using the duration relationship:

∆G
Consider a portfolio of options on a single stock with current price S:
∆=
∆
If we indicate the return on the stock in one day as ∆Š, we can write:
∆G = ∗ ∆ ∗ ∆Š
This is a linear relationship between ∆G and ∆Š. For several underlying market variables:
q q

∆G = m n ∆n ∆Šn = m :n∗ ∆Šn

n…( n…(
This is the so-calles linear model.

Example:

∆1n¡FÁ = 1000, ∆Â>&> = 20000, 1n¡FÁ = 120, Â>&> = 30

Portfolio of options on Microsoft ant AT&T shares.

⟹ ∆G = 120 ∗ 1000 ∗ ∆Š + 30 ∗ 20000 ∗ ∆i

) = 120 ∗ 0.02 + 600 ∗ 0.01 + 2 ∗ 0.3 ∗ 120 ∗ 0.02 ∗ 600 ∗ 0.01 = 7.099
If we assume the same data as before for volatilities and correlation then in 1000 dollars:

⟹ z6 •b = 1.6448 ∗ 7099 = 11676.82

If we introduce Γ in our computations:

1
∆G = ∆ ∗ ∆ ∗ Γ ∆
2
Settin ∆Š =
∆B
B
1
, we get:

∆G = ∗ ∆ ∗ ∆Š + S Γ ∆Š
2

For a portfolio for n underlying market variables:

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q q q
1
∆G = m n ∆n ∆Šn + m m n Ä ΓÉÊ ∆ŠÄ
2
n…( n…( Ä…(
With ΓÉÊ = ]B ]B . This is not always easy to compute. A good trick is to use Cornisch-
];
p Ë
Fisher expansion, which allow us to estimate the quantile of a distribution using its

‰E67 ; = ∆G
moments. The first three moments:

z6 $67lE ); = ∆G − ∆G
∆G w − 3 ∆G ; +2 ;
w
kE—7E%% ®; =
);w

z6 { = ; + '{ );
The Cornish-Fisher expansion tells us that:

Where '{ = t{ + Œ t{ − 1 ®; , t{ is q-quantile of the standard normal distribution

(

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Lessons 18&19

Credit Risk is the risk that the value of a portfolio changes due(als gevolg van) to
unexpected changes in the credit quality of issuers or trading partners. This subsumes
both losses due to defaults(wanbetalingen) and losses caused by changes in credit quality
of a counterparty in an internal or external rating system.

There are two main areas of application of risk modeling:

• Credit Risk management models for (Static):
o The determination of the loss distribution of a loan or bond portfolio.
o The copmutation of loss-distribution-based risk measures
o The optimal allocation of risk-capital
• Analysis of credit-risky securities (Dynamic)
Risk models are classified: 1. Structural or firm-value models 2. Reduced-form models.

1. Default occurs whenever a stochastic

variable representing some asset value
falls below a given threshold representing
liabilities. (wanbetaling treedt op wanner
een variabele die een bepaalde intrinsieke
waarde heeft onder een drempel komt die
verplichting)
2. The default of a company represented by a
non-negative random variable, whose
distribution depends on some economic
covariables.

Dependence in risk modeling. Even if some risk

models asuume the independence of a defaults, its
quite easy to understand that dependence plays an
fundamental role in reality. In the picture you see that in
one portfolio defaults are assumed to be independent. In
other one a correlation equal to 0.15% is assumed. The
difference between the two distributions is clear: in the
case of dependence, a large number of defaults may happen
with higher probability.

In a structural model. One tries to explain the mechanism

by wich defaults take place. As said: default generally
occurs whenever a stochastic variable(or process)
representing some asset value falls below a given threshold
representing liabilities.(Xt is a stochastic process in continuous time(time is non-negative)

The Merton Model: We consider Ltd company whose asset value follow some stochastic
process(Vt). This company can finance itself by equities or by debt. Debt represented by
one single debt obligation with face value B and maturity T. St denotes the value of

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equity at time t, while Bt represents the debt. The value of the firm’s assets at time t is
given by:
Vt = St + Bt, 0 ≤ t ≤ T
An important assumption of the Merton Model is that a firm cannot pays dividend or
issue new debt. Defaults occurs if the firm is not able to pay debt holders, (by missing a
payment on debt) In the basic model this may happen only at maturity T.

• z> > Ì The debt holders receive B, while that share holders receive the residual:
Two difference scenarios at time T:

Ì> = Ì, > = z> − Ì

• z> ≤ Ì Share holders do not have any interest in providing new capitcal, since it
would go directly to debt holders. Instead, they hand over control of the firms to
debt holders by exercising the limited liability option. Debt holders thus liquidate

Ì> = z> , > = 0

the company and distribute the revenues among them:

> = z> − Ì
P
Summarize:

Ì> = Ì − Ì − z> P
The Merton model is able to give an effective view of the potential conflict of interest
between shareholders and debt holders in a company: the first have an interest in the firm
investing in risky projects (that increase the volatility of the underlying “security”), while
the second prefer a less volatile and less risky asset value.

The default probability:

KMV Model is an important example of industry model derived from the simple Merton.
A fundamental quantity in the KMV model is the Expected Default Frequency (EDF); the
probability that a firm will default within 1 year according to the KMV methodology.

Firm-valued models aften take the market value of the firm’s assets as a primitive.
However, its know that the true market value of a company is not fully observable:
• Market value can strongly differ from the value of company as measured bij
accountancy rules.
• The market value of a company corresponds to the sum of the market values of its
equity and debt. But while the market value of equities is known, as far as debt
are concerned, only a relatively small part of firm’s debt is fully knowable.

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