11/27/2020

Financial Risk Measurement and Management

Session 10

Dilip Kumar 1

EGARCH model
Suggested by Nelson (1991). The variance equation is given by
2
log = + − + log +

Advantages of the model

- Since we model the log(t2), then even if the parameters are negative, t2
will be positive.
- We can account for the leverage effect: if the relationship between
volatility and returns is negative, , will be negative

Dilip Kumar 2

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Technical Note: A critical shortcoming of RiskMetrics

The GARCH (1,1) model can be written as:
=+ +
A standard condition for GARCH model to be stable is that  + < 1. If
you view RiskMetrics model as a special case of GARCH, then it isn’t
stable!
• Remember in RiskMetrics: =0,  = 1 - , =
It is easy to see why this condition must be true. Denote by the long-
run variance. It can be expressed as
= =+ +
=+ +
=
1− +

Dilip Kumar 3

Technical Note: A critical shortcoming of RiskMetrics

The long-run variance of the GARCH model is given as:
=
1− +
For the long-run variance to remain stable, the denominator in the
above has to be non-zero i.e.,  + < 1.
However, when we view RiskMetrics model as a special case of GARCH,
then  = 1 - , = . Hence,  + = 1, meaning that the long-run
variance in GARCH isn’t stable!
To be precise, given that =0, is the long-run variance even well defined?
This highlights one of the critical short-comings of RiskMetrics model
It yields an unstable long-run average for the variance!

Dilip Kumar 4

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In-class Exercise
As on 3 Jan 2005, you have the following portfolio:
Infosys SBI
Spot Price 264.94 61.86
Units 100 428
The position has been chosen so that both stocks have roughly the
same weight (0.5002, 0.4998) in the portfolio.
Evaluate the 1-day 95% VaR for the portfolio.
Concept check:
What did you assume as constant – the weights or the number of units?

Dilip Kumar 5

Let us look at the data first …

Below is a plot of returns of Infosys and SBI stocks
Needless to say, it doesn’t say much!
Let us look at the prices themselves
30.000%

20.000%

10.000%

0.000%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
-10.000%

-20.000%

-30.000%
SBI Infosys

Dilip Kumar 6

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Let us look at the data first …

Below is a plot of Infosys and SBI stocks prices
If you are a risk modeler looking at the below chart, what would be the
1400
most important observation that you would make?
1200
1000
800
600
400
200
0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
SBI Infosys

Dilip Kumar 7

Method I: Standard correlation / covariance

Earlier, while dealing with the single assets, we assumed the asset’s
variance to be variable and calculated it using a rolling windows
Now, we additionally assume the covariance to be variable and calculate it using a
rolling window
Remember: If a portfolio has two stocks (A and B), the following holds:
= +
= + +2
Where is the covariance between the two stocks; it can also be
expressed in terms of correlation, , as
=

Dilip Kumar 8

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Method I: Standard correlation / covariance

Step-by-step approach for calculating the VaR of a portfolio
For each stock, calculate the daily log returns for the entire period
For each stock, create a series of variance forecasts using a 252-day rolling
window.
Next, create a series of covariance forecasts using a 252-day rolling window
Calculate the volatility forecast for the portfolio using the expression
= + +2
Estimate VaR for portfolio using
, = 1.645 × , × ,
Estimate the breach percentage.
Note: Why don’t we directly look at the returns of the portfolio?
Dilip Kumar 9

Method I: Standard correlation / covariance

Before we examine the performance of VaR, let us examine how
well the correlation adapts itself to changing market conditions
1400 0.6

1200 0.5
0.4
1000
0.3
Correlation

800
Price

0.2
600
0.1
400
0
200 -0.1
0 -0.2
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
SBI Infosys Correlation

Dilip Kumar 10

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Method I: Standard correlation / covariance

Below is a plot of VaR and actual P&L
20000

15000

10000

5000
Portfolio VaR
0
Actual PnL
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
-5000

-10000

-15000

-20000

There were a total of 143 breaches, accounting for a moderate 4.93%

breaches.
Dilip Kumar 11

Method I: Standard correlation / covariance

Conclusion: This method seems to be doing reasonably fine in
back-testing analysis. However, a major shortcoming of the
method is the “staleness” of the correlation/covariance forecast.
1400 0.6
1200 0.5

1000 0.4
Correlation

0.3
800
Price

0.2
600
0.1
400 0
200 -0.1
0 -0.2
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
SBI Infosys Correlation
Dilip Kumar 12