Quantitative Risk

Management
Measures of Financial Risk
Learning objectives

• Describe the mean-variance framework and the efficient frontier.

• Explain the limitations of the mean-variance framework with respect to
assumptions about return distributions.
• Compare the normal distribution with the typical distribution of returns
of risky financial assets such as equities.
• Define the VaR measure of risk, describe assumptions about return
distributions and holding period, and explain the limitations of VaR.
Learning objectives

• Explain and calculate Expected Shortfall

(ES), and compare and contrast VaR and
ES.
• Define the properties of a coherent risk
measure and explain the meaning of
each property.
• Explain why VaR is not a coherent risk
measure.
• Describe spectral risk measures, and
explain how VaR and ES are special
cases of spectral risk measures.
THE MEAN-VARIANCE
FRAMEWORK AND THE
EFFICIENT FRONTIER
▪ The mean-variance framework
uses the expected mean and
standard deviation to measure
the financial risk of portfolios.
▪ The normal distribution is
particularly common because
it concentrates most of the
data around the mean return.
THE MEAN-VARIANCE FRAMEWORK AND THE
EFFICIENT FRONTIER
Investors are normally concerned with downside risk and are therefore
interested in probabilities that lie to the left of the expected mean.

The efficient frontier represents the set of optimal portfolios that offers
the highest expected return for a defined level of risk.

For every point on the efficient frontier, there is at least one portfolio that
can be constructed from all available investments that has the expected
risk and return corresponding to that point.
THE MEAN-VARIANCE
FRAMEWORK AND THE
EFFICIENT FRONTIER

• The choice between

optimal portfolios A, B
and D above will
depend on individual
investor’s appetite for
risk
LIMITATIONS OF THE MEAN-VARIANCE
FRAMEWORK
LIMITATIONS OF THE MEAN-VARIANCE
FRAMEWORK
• Fat tail distribution
VALUE AT RISK AS A MEASURE
OF RISK
• Value at Risk (VaR) can be
defined as the maximum
amount of loss, under
normal business conditions,
that can be incurred with a
given confidence interval.
➢It can also be viewed as the
worst possible loss under
normal conditions over a
specified period.
 VALUE AT RISK AS A MEASURE OF RISK
• Suppose an analyst calculates the monthly VaR as $100 million at 95% confidence: What
does this imply?
➢ This simply means that under normal conditions, in 95% of the months, we expect the
fund to lose no more than $100 million.
➢ Put differently, the probability of losing $100 million or more in any given month is 5%.
 VaR does not describe the worst possible loss.

VaR indicates the probability of a value occurring but stops

short of describing the distribution of losses in the left tail.

LIMITATIONS Two arbitrary parameters are used in its calculation-the

confidence level and the holding period.
OF VaR
a. The confidence level indicates the probability of obtaining
a value greater. VaR increases at an increasing rate as the
confidence level increases.

b. The holding period is the time span during which we

expect the loss to be incurred, say, a week, month, day or
year. VaR also increases with increases in the holding period.
PROPERTIES OF A COHERENT RISK
MEASURE
• A risk measure summarizes the entire distribution of dollar returns 𝑋 by
one number, 𝜌(𝑋). There are four properties every risk measure should
possess:
1. Monotonicity: if 𝑋1 ≤ 𝑋2 , 𝜌 𝑋1 ≥ 𝜌(𝑋2 ) ;
If a portfolio has systematically lower values than another, in each state of
the world, it must have greater risk.
2. Subadditivity: 𝜌 𝑋1 + 𝑋2 ≤ 𝜌 𝑋1 + 𝜌 𝑋2 ;
when two portfolios are combined, their total risk should be less than (or
equal to) the sum of their individual risks; Merging of portfolio ought to
reduce risk.
PROPERTIES OF A COHERENT RISK
MEASURE
3. Homogeneity: 𝜌 𝑘𝑋 = 𝑘𝜌(𝑋);
Increasing the size of a portfolio by a factor k should result in a
proportionate scale in its risk measure.
4. Translation invariance: 𝜌 𝑋 + ℎ = 𝜌 𝑋 − ℎ;
Adding cash ℎ to a portfolio should reduce its risk by ℎ.
 VaR violates the subadditivity principle
and it is not a coherent risk measure.
WHY VaR IS
NOT A This means that VaR has no claim to be
regarded as a ‘proper’ risk measure at all.
COHERENT
RISK VaR is merely a quantile.

MEASURE So which risk measure should risk

managers use?
EXPECTED SHORTFALL
EXPECTED SHORTFALL
SPECTRAL RISK MEASURES
• A spectral risk measure is a risk measure given as a weighted
average of return quantiles from the loss distribution.
➢A spectral risk is always is a coherent risk measure.
• ES is a special case of risk spectrum measurement.
Calculating and Applying VaR

• Explain and give examples of linear and non-linear derivatives.

• Describe and calculate VaR for linear derivatives.
• Describe and explain the historical simulation approach for computing VaR
and ES.
• Describe the delta-normal approach for calculating VaR for non-linear
derivatives.
• Describe the limitations of the delta-normal method.
• Explain the full revaluation method for computing VaR.
Calculating and Applying VaR

• Compare delta-normal and full revaluation approaches for computing VaR.

• Explain structured Monte Carlo and stress testing methods for computing
VaR, and identify strengths and weaknesses of each approach.
• Describe the implications of correlation breakdown for scenario analysis.
• Describe worst-case scenario (WCS) analysis and compare WCS to VaR.
LINEAR VS. NONLINEAR DERIVATIVES

• A linear derivative is one whose value is directly related to the market price of the underlying
variable.
➢ If the underlying makes a move, the value of the derivative moves with a nearly identical margin.
➢ Examples include futures and forwards contracts.
• A non-linear derivative is one whose value/payoff changes with time and space
• Space, in this case, refers to the location of the strike/exercise price with respect to the
spot/current price.
• For non-linear derivatives, delta is not constant. Rather, it keeps on changing with the change in
the underlying asset.
• Examples include the Vanilla European option, Vanilla American option, Bermudan option, etc.
VaR FOR LINEAR DERIVATIVES

• In general terms, the VaR of a linear derivative can be expressed as:

𝑉𝑎𝑅𝑙𝑖𝑛𝑒𝑎𝑟 𝑑𝑒𝑟𝑖𝑣𝑎𝑡𝑖𝑣𝑒 = Δ × 𝑉𝑎𝑅𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟
• Where Δ represents the sensitivity of the derivative’s price to the price of
the underlying asset. Its usually expressed as a percentage.
DELTA-NORMAL VaR

• The Delta-normal VaR calculation approach

involves the delta approximation for non-
linear derivatives.
• The linear approximation is often used in
conjunction with a normality assumption for
the distribution.
• The formula is: 𝑉𝑎𝑅 = Δ ×
𝑉𝑎𝑅𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑎𝑙𝑙 𝑣𝑎𝑙𝑢𝑒
• Where Δ =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
DELTA-NORMAL VaR

• The method has several disadvantages, a mong them being that:

• It’s computationally easy but quite inaccurate compared to other VaR
measurement methods.
• Put more precisely, it may underestimate the occurrence of extreme losses
because of its reliance on the normal distribution.
• This method is accurate for small moves of the underlying, but quite
inaccurate for large moves.
FULL REVALUATION VaR

▪ Under the full revaluation approach, the VaR of a portfolio is established by fully repricing the
portfolio under a set of scenarios over a period of time.
✓ It’s hugely popular because it generates reliable VaR estimates.
✓ It’s the preferred method for options, especially in the presence of large movements of risk
factors.
▪ Full revaluation has several advantages over the delta-normal approach.
✓ It accounts for nonlinear relationships.
✓ It accounts for extreme observations.
▪ However, computations can be particularly burdensome, for instance when repricing complex
MBSs, swaptions, or exotic options.
MEASURING AND
MONITORING VOLATILITY
• Explain how asset return distributions tend to deviate from
the normal distribution.
• Explain reasons for fat tails in a return distribution and
describe their implications.
• Distinguish between conditional and unconditional
distributions.
• Describe the implications of regime switching on
quantifying volatility.
• Evaluate the various approaches for estimating VaR.
MEASURING AND
MONITORING VOLATILITY
• Compare and contrast different parametric and non-
parametric approaches for estimating conditional volatility.
• Calculate conditional volatility using parametric and non-
parametric approaches.
• Evaluate implied volatility as a predictor of future volatility
and its shortcomings.
• Explain and apply approaches to estimate long horizon
volatility/VaR, and describe the process of mean reversion
according to a GARCH (1,1) model.
• Apply the exponentially weighted moving average (EWMA)
approach and the GARCH (1,1) model to estimate volatility.
MEASURING AND
MONITORING VOLATILITY
• Deviation from normality: There are three ways in which
an asset's return can deviate from normality:
✓ The return distribution can have fatter tails than a normal
distribution.
✓ The return distribution can be non-symmetrical.
✓ The return distribution can be unstable with parameters
that vary through time.
• Unconditional and conditional normality:
MEASURING AND
MONITORING VOLATILITY
• How is volatility measured:
✓ In risk management, the volatility of an asset is the
standard deviation of its return
• Estimating the current volatility:
✓ Exponential Smoothing: The exponentially weighted
moving average (EWMA):
2 2
𝜎𝑛2 = 1 − 𝜆 𝑟𝑛−1 + 𝜆𝜎𝑛−1
→ Determining 𝜆?
✓ The GARCH model.