Fixed Income Markets & Securities

Value at Risk I

Session 34 and 35
April 15, 2020
Bennett University
Rajib Sarkar

Rajib Sarkar
1
Bennett University
 Value at Risk (VaR)
• Value at risk (VaR) is one of the most widely used risk
measures in finance. VaR was popularized by J.P. Morgan in
the 1990s. The executives at J.P. Morgan wanted their risk
managers to generate one statistic at the end of each day,
which summarized the risk of the firm’s entire portfolio.
What they came up with was VaR.

• If the 95% VaR of a portfolio is Rs.100, then we expect the

portfolio will lose Rs.100 or less in 95% of the scenarios,
and lose Rs.100 or more in 5% of the scenarios. We can
define VaR for any confidence level, but 95% has become
an extremely popular choice in finance.

Bennett University
2
Rajib Sarkar
 Parametric VaR (Delta Normal VaR)

• In this simple method 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.

• For portfolios, the delta normal model assumes

that the relationships between securities can be
fully described by their correlation.

• Confidence level and the time horizons are the

parameters in this model
Bennett University
3
Rajib Sarkar
Basic VaR Models

Bennett University
4
Rajib Sarkar
The Question Being Asked in VaR

“What loss level is such that we are X%

confident it will not be exceeded in N business
days?”

Bennett University
5
Rajib Sarkar
 Advantages of VaR
• It captures an important aspect of risk in a
single number

• It is easy to understand

• It asks the simple question: “How bad can

things get?”

Bennett University
6
Rajib Sarkar
 VaR and Regulatory Capital
• Regulators base the capital they require
banks to keep on VaR

• The market-risk capital has traditionally been

calculated from a 10-day VaR estimated
where the confidence level is 99%

• Credit risk and operational risk capital are

based on a one-year 99.9% VaR

Bennett University
7
Rajib Sarkar
Expressing VaR Mathematically

Where the LHS is the probability of loss (L being the magnitude of loss)
being higher than VaR and c on the RHS is Confidence Level

Bennett University
8
Rajib Sarkar
Parametric or Delta Normal Valuation
of VaR

Bennett University
9
Rajib Sarkar
 Illustrative Example I : Continuous (Normal) Distribution

• The gain from a portfolio during six month is

normally distributed with mean Rs.2 million and
standard deviation Rs.10 crore.

• The 1% point of the distribution of gains is

2−2.33×10 or − Rs.21.3 crore.

• The VaR for the portfolio with a six month time

horizon and a 99% confidence level is Rs.21.3
crore.

Bennett University
10
Rajib Sarkar