Risk Management: University of Leeds

Risk Management
Lecture 2
Miryana Grigorova
University of Leeds
Week 2, June 2021
Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 1 / 41

In this lecture
Losses and risk factors: Examples

Risk measures
I Definition, Properties,...
I Examples
F Value at Risk
F Expected Shortfall.
VaR and ES in detail

Modeling Risks and Losses
The Model
Consider a portfolio.
Let Vt denote the value of the portfolio at time t.
−→ We assume that Vt is a random variable on (Ω, F , P).
Vt +∆ is the value of the portfolio at time t + ∆.
−→ Vt +∆ is also a random variable.
The difference Vt +∆ − Vt corresponds to the profit over the time
period from t to t + ∆.
We set Lt +∆ := −(Vt +∆ − Vt ).
−→ The r.v. Lt +∆ corresponds to the loss over the time period
from t to t + ∆.
item Terminology: The probability distribution of the r.v. Lt +∆ is
called the loss distribution.

Risk factors
We assume that there are d risk factors (where d ∈ {1, 2, . . . , })

having an influence on the portfolio value (hence, on the loss).

Risk factors

The value of risk factor i at time t is modelled by a random
variable, denoted by Zti .
We denote by Zt the random vector Zt = (Zt1 , Zt2 , . . . , Ztd )0 .

Risk factors

The value of risk factor i at time t is modelled by a random
variable, denoted by Zti .
We denote by Zt the random vector Zt = (Zt1 , Zt2 , . . . , Ztd )0 .
Examples of risk factors: (logarithmic) prices of financial assets;

yields; (logarithmic) exchange rates;...

The model assumes:

The value Vt of the portfolio at time t can be expressed as a
deterministic function f of time and of the risk factors (at time t).

The model assumes:

The value Vt of the portfolio at time t can be expressed as a
deterministic function f of time and of the risk factors (at time t).
With mathematical notation,
Vt = f (t , Zt ) = f (t , Zt1 , Zt2 , . . . , Ztd ),
where f is a given deterministic (that is, non-stochastic) function

from R+ × Rd to R.

Risk factors
Assumption
f is a known differentiable function,
Zt is a d-dimensional random vector observable at time t,
but Zt +∆ is unknown at time t.

Risk factors
Assumption
f is a known differentiable function,
Zt is a d-dimensional random vector observable at time t,
but Zt +∆ is unknown at time t.
We set:
Xt +∆ := Zt +∆ − Zt .
The random vector Xt +∆ corresponds to the change in the risk
factors (or risk factors change) between time instants t and t + ∆.

With the above notation, the portfolio loss Lt +∆ at time t + ∆ can be

expressed as follows:
Lt +∆ = −(Vt +∆ − Vt )

= − f (t + ∆, Zt +∆ ) − f (t , Zt )

= − f (t + ∆, Zt + Xt +∆ ) − f (t , Zt ) .
Remark: The first equality comes from the definition of the loss, the
second comes from the model, and the third comes from the definition
of the risk factors change.

In the last lecture,

We also learnt how to approximate Lt +∆
by using linear approximation
(that is, Taylor approximation at order 1).

By using first order Taylor approximation, we showed that:
The loss Lt +∆ can be approximated by the linearized loss Llin

t +∆ , where
!
d
∂f ∂f
Llin
t +∆ = − (t , Zt )∆ + ∑ (t , Zt )Xti+∆ .
∂t i =1 ∂zi

Example: The case of a portfolio of stocks

We consider a self-financing portfolio of d stocks.
We denote by λit the number of shares of stock i in the portfolio at
time t (where i = 1, . . . , d).
We denote by Sti the price of stock i at time t.
Then, we have Vt =


time t (where i = 1, . . . , d).
Then, we have Vt = ∑di=1 λit Sti and Vt +∆ =


time t (where i = 1, . . . , d).
Then, we have Vt = ∑di=1 λit Sti and Vt +∆ = ∑di=1 λit +∆ Sti +∆ .
By the self-financing condition (cf. Discrete-time finance),
we have
d d
Vt +∆ = ∑ λit +∆Sti +∆ = ∑ λit Sti +∆
i =1 i =1
Hence, the loss Lt +∆ can be expressed
Lt +∆ = −(Vt +∆ − Vt )
d d d
= −( ∑ λit Sti +∆ − ∑ λit Sti ) = −( ∑ λit (Sti +∆ − Sti )).
i =1 i =1 i =1
It is standard practice in risk management to use the logarithmic

stock prices as risk factors.
So, in this example, Zti := ln Sti .
The value of the portfolio at t in this example is thus
d d d
i i
Vt = ∑ λit Sti = ∑ λit eln(St ) = ∑ λit eZ . t
i =1 i =1 i =1
The value of the portfolio at t + ∆ in this example satisfies
d d d
i i
Vt +∆ = ∑ λit Sti +∆ = ∑ λit eln(St +∆) = ∑ λit eZ +∆ .
t
i =1 i =1 i =1

The change of risk factor i between t and t + ∆:
Xti+∆ = Zti+∆ − Zti = ln Sti +∆ − ln Sti .
−→ Hence, in this example, Xti+∆ corresponds to the log-return of

stock i.
Portfolio loss Lt +∆ expressed in terms of the factor changes
d d
i i i
Lt +∆ = − ∑ λit eZt (eXt +∆ − 1) = − ∑ λit Sti (eXt +∆ − 1).
i =1 i =1
Question: What is the expression for the function f in this

example?

Recall that the value of the portfolio at t in this example is:

d d d
i i
Vt = ∑ λit Sti = ∑ λit eln(St ) = ∑ λit eZ .
t
i =1 i =1 i =1
We will see that this example enters into the framework presented
in Lecture 1.
Indeed, let us place ourselves at time t (fixed) and we consider the
period from t to t + ∆.
Let λ1 be the realization of λ1t ,
Let λ2 be the realization of λ2t , ...,
let λd be the realization of λdt .
Let z 1 be the realization of Zt1 ,
Let z 2 be the realization of Zt2 , ...,
let z d be the realization of Ztd .
The function f in this example is equal to
d
1 2 d
f (z , z , . . . , z ) = ∑ λi exp(z i ).
Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 i =1 13 / 41
Question: What is the expression for the linearized loss Llin

t +∆ in
this example?
For this, we need first to compute the partial derivatives of the

function f (cf. whiteboard).
d
i
Llin Zt i
t +∆ = − ∑ λi e Xt +∆
i =1
d
= − ∑ λi Sti Xti+∆ .
i =1
The linearized loss Llin

t +∆ is an approximation of the loss Lt +∆ .

Example: The case of a portfolio of one option
Example: A portfolio of one call option
Portfolio consisting of one call option on a stock S with maturity date T

and exercise price K
It can be shown that, the price of the call at time t is:
c (t , St , rt , σt ; K , T ),
where c is a deterministic function (for the proof, cf. later in

Continuous-time finance).
Risk factors: log-price of the stock, interest rate and volatility, that
is Zt = (ln St , rt , σt )0
Vt +∆ = c (t + ∆, St +∆ , rt +∆ , σt +∆ ; K , T )

Example: A portfolio of one call option
Risk-factor changes:
Xt +∆ = (Xt1+∆ , Xt2+∆ , Xt3+∆ )0 = (ln St +∆ −ln St , rt +∆ − rt , σt +∆ −σt )0
Loss:
Lt +∆ = − (c (t + ∆, St +∆ , rt +∆ , σt +∆ ; K , T ) − c (t , St , rt , σt ; K , T ))
Here, the function f equals to the function c.

Linearized loss:
Llin
t +∆ =?

Where do we get the Loss distribution from?
There are different approaches (or methods) used in practice.

Analytical approach: choose a model for the risk factor change
Xt +∆ and a mapping function f , so that Lt +∆ can be expressed
analytically.
Example: the so-called variance-covariance method
Historical estimation: estimating the loss distribution by using the
empirical distribution of past risk factor changes. Hypotheses?
Monte Carlo approach: simulation of an explicit parametric model
for risk factor changes.
We will have a closer look at these approaches later on in the lectures.

Risk measures
Idea: A risk measure is a mapping which associates to a loss L a real

number (which indicates its riskiness).
Why are risk measures useful?
Determination of risk capital: determine the amount of capital a
financial institution needs to cover unexpected losses.
Management tool: risk measures are used by management to limit
the amount of risk a unit within the firm may take.
Insurance premiums:
compensation paid by the insured to the insurance company are
based on measure of risk of the insured claims.

Risk measures
We will now introduce the notions of risk measure, monetary risk

measure, convex risk measure and coherent risk measure.
An important theoretical contribution is that of Artzner, Delbaen, Eber,
Heath (1999, journal Mathematical Finance).
We consider a one-period framework.
We thus have two dates: today (the date 0) and a future date ∆.
The loss from 0 to ∆ is denoted by L∆ or, simply by L.
Recall that this is a random variable on (Ω, F , P ).
We denote by M be the set of all random variables.
Note that M is a linear vector space.

Risk measures
Risk measure
Definition
A mapping ρ : M → R is called risk measure if it satisfies:
(A1) (Monotonicity) If L1 ≤ L2 , then ρ(L1 ) ≤ ρ(L2 ).
What is the financial interpretation of the property of monotonicity?

Risk measures
Monetary Risk measure
Definition
A mapping ρ : M → R is called a monetary risk measure if it satisfies:
(A2) (Translation invariance) For every L ∈ M , for every m ∈ R,
ρ(L + m) = ρ(L) + m.
Terminology: The property of translation invariance is also known as

cash invariance.
What is the financial interpretation of the property of translation

invariance?

Risk measures
Convex risk measure
Definition
A mapping ρ : M → R is called convex risk measure if it satisfies :
(A2) (Translation invariance) For every L ∈ M , for every m ∈ R,
ρ(L + m) = ρ(L) + m.
(A3) (Convexity) For every L1 , L2 ∈ M and every λ ∈ [0, 1],
ρ(λL1 + (1 − λ)L2 ) ≤ λρ(L1 ) + (1 − λ)ρ(L2 ).
What is the financial interpretation of the property of convexity?

Risk measures
Coherent risk measure
Definition
A mapping ρ : M → R is called coherent risk measure if it satisfies:
(A2) (Translation invariance) For every L ∈ M , m ∈ R,
ρ(L + m) = ρ(L) + m.
(A3) (Convexity) For every L1 , L2 ∈ M and every λ ∈ [0, 1],
ρ(λL1 + (1 − λ)L2 ) ≤ λρ(L1 ) + (1 − λ)ρ(L2 ).

(A4) (Positive homogeneity) For every L ∈ M , for every positive
number c,
ρ(cL) = c ρ(L).
What is the financial interpretation of positive homogeneity?

Risk measures
Relations between the different classes of risk measures

−→ picture on the board.

Risk measures
First (very easy) example
Let us consider ρ : M → R defined by
ρ(L) = E (L).
In order for ρ to be well-defined in this example,

we restrict ourselves to random variables L having a finite expectation.
Questions:
Is the mapping ρ in this example a risk measure?
Is ρ a monetary risk measure?
Is ρ convex?
Is ρ coherent?

Risk measures Value at Risk
Value at Risk (VaR)
Let us fix a given level α ∈ (0, 1) (known as the confidence level).
In practice, α = 95%, α = 99%, α = 99.9%.
The Value at Risk at confidence level α (denoted by VaRα ) is the

smallest number l such that the probability that the loss L exceeds l is
no larger than (1 − α).
More precisely, we have the following definition:
VaRα (L) = inf{l ∈ R : P (L > l ) ≤ 1 − α}.

We will now provide a connexion between VaR of L and the quantile

function of L.
For this, let us recall the definition of the quantile function and some
properties.

Quantile function (Revision)
Let X be a random variable.

Let FX be a the cumulative distribution function of the r.v. X .
Definition
The quantile function qX of X is defined by:
qX (y ) = inf{x ∈ R : FX (x ) ≥ y }, for all y ∈ (0, 1).
Terminology: The function qX is also known as the LOWER quantile

function of X , or the LEFT-Continuous quantile function of X .
Terminology: Fix a point y ∈ (0, 1). The number qX (y ) is known as
the quantile of X at level y , or the y -quantile of X .

Some properties:
The quantile function qX is non-decreasing.
The quantile function qX is left-continuous with right limits.

Proposition
(The case where F is increasing and continuous)
Let FX be a given CDF.
We assume that FX is increasing and continuous.
Then,
FX is an invertible function.
Moreover,
qX (y ) = FX−1 (y ), for all y ∈ (0, 1),
where FX−1 denotes the (usual) inverse function of FX .

Back to the VaR

Recall the definition of the VaR at level α:
VaRα (L) = inf{l ∈ R : P (L > l ) ≤ 1 − α}.
Let us denote by FL the CDF of L,

that is, FL (x ) = P (L ≤ x ), for all x ∈ R.
Then we have
VaRα (L) = inf{l ∈ R : P (L > l ) ≤ 1 − α}
= inf{l ∈ R : FL (l ) ≥ α}
= qL (α).
Conclusion: The VaR of the loss L at level α is equal to the
α-quantile of the loss L.
−→ Practical advice: It is useful to know properties of quantile
functions, as we can easily deduce properties of the VaR.
Question: Is VaRα a risk measure?
Theorem
Let α ∈ (0, 1) be a fixed confidence level.
We have:
(Monotonicity) If L1 ≤ L2 , then VaRα (L1 ) ≤ VaRα (L2 ).
(Translation invariance) For every r.v. L, for every m ∈ R,
VaRα (L + m) = VaRα (L) + m.
(Positive Homogeneity) For every r.v. L, for every positive number
c,
VaRα (cL) = cVaRα (L).
Proof: on the board.

Caveat: VaRα is not convex!
A counter-example will be given in the next lecture.
Remember:
VaRα is a monetary risk measure which satisfies positive homogeneity.
But, VaRα is not a convex risk measure (as it does nor satisfy the
property of convexity).

Advantage: VaRα is simple to use

(it is just the α − quantile of the distribution of the loss).
Drawback: VaR does not provide information about the size of the
losses which might occur with probability less than 1 − α.
Drawback: Negative diversification effects can arise
(as VaRα is not convex).
VaRα is widely used by practitioners.

The EU insurance regulatory framework Solvency II prescribes the use
of Value at Risk with a confidence level α = 99.5% for the computation
of the so-called Solvency Capital Requirement (SCR).

Particular case: VaR in the case of normal distribution
Let m ∈ R and σ2 6= 0.
Property
If L ∼ N (m, σ2 ), then
VaR α (L) = m + σΦ−1 (α).
Here (as usual), Φ denotes the CDF of the standard normal N (0, 1).

Risk measures Expected Shortfall (or Average Value at Risk)
Expected shortfall (also Average VaR)

Let L be a random variable such that E (|L|) < ∞.
The expected shortfall of L at level α is defined by
1
Z 1
ESα (L) = VaRu (L) du .
1−α α
Note that ESα is well-defined for random variables which have a finite
first moment.
Remark: ESα is very popular among practitioners.

ESα is recommended in the Swiss Solvency Test (SST), which is the
insurance regulatory framework in Switzerland.

Theorem
We have:
(Monotonicity) If L1 ≤ L2 , then ESα (L1 ) ≤ ESα (L2 ).
(Translation invariance) For every r.v. L, for every m ∈ R,
ESα (L + m) = ESα (L) + m.
(Convexity) For every L1 , L2 and every λ ∈ [0, 1],
ESα (λL1 + (1 − λ)L2 ) ≤ λESα (L1 ) + (1 − λ)ESα (L2 ).
(Positive Homogeneity) For every r.v. L, for every positive number

c,
ESα (cL) = cESα (L).
It follows from the Theorem that ESα is a coherent risk measure.

Equivalent expression in the case where FL is continuous

If the CDF FL is a continuous function, then the expected shortfall at
level α can be expressed as follows:
ESα (L) = E (L|L ≥ VaRα (L)).
In other words, when FL is continuous, the expected shortfall at α is

equal to the expected loss conditioned on the event that VaR at α is
exceeded.

Particular case: ESα for normal distribution
If L ∼ N (µ, σ2 ), then
φ Φ−1 (α)

−1

ESα (L) = µ + σE Z |Z ≥ Φ (α) = µ + σ
1−α
where φ denotes de density function of the standard normal N (0, 1).
Note that we have φ = Φ0 .

Complements on quantile functions and their usefulness
Proposition
(Quantile transformation of a uniform random variable)
Let U be a r.v. such that U ∼ U (0, 1) (uniform distribution on the
interval (0, 1)).
Let X be a random variable with quantile function qX .
Set Y = qX (U ).
Then, the random variable Y and the random variable X have the same
distribution. That is,
FY (x ) = FqX (U ) (x ) = FX (x ), for all x ∈ R.
This proposition is very useful for simulating from a given distribution.

Complements on quantile functions and their usefulness
Proposition
Let X be a random variable.
Let FX be a the cumulative distribution function of the r.v. X .
Assume moreover that the CDF FX is a continuous function.
Set U = FX (X ). Then, the random variable U = FX (X ) has the Uniform
distribution U (0, 1).

Risk Management: University of Leeds

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Risk Management

Week 2, June 2021

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 1 / 41

Losses and risk factors: Examples

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 2 / 41

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 3 / 41

We assume that there are d risk factors (where d ∈ {1, 2, . . . , })

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 4 / 41

We assume that there are d risk factors (where d ∈ {1, 2, . . . , })

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 4 / 41

We assume that there are d risk factors (where d ∈ {1, 2, . . . , })

Examples of risk factors: (logarithmic) prices of financial assets;

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 4 / 41

The model assumes:

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 5 / 41

The model assumes:

With mathematical notation,

Vt = f (t , Zt ) = f (t , Zt1 , Zt2 , . . . , Ztd ),

where f is a given deterministic (that is, non-stochastic) function

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 5 / 41

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 6 / 41

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 6 / 41

With the above notation, the portfolio loss Lt +∆ at time t + ∆ can be

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 7 / 41

In the last lecture,

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 8 / 41

By using first order Taylor approximation, we showed that:

The loss Lt +∆ can be approximated by the linearized loss Llin

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 9 / 41

Example: The case of a portfolio of stocks

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 10 / 41

Example: The case of a portfolio of stocks

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 10 / 41

Example: The case of a portfolio of stocks

It is standard practice in risk management to use the logarithmic

The value of the portfolio at t + ∆ in this example satisfies

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 11 / 41

The change of risk factor i between t and t + ∆:

Xti+∆ = Zti+∆ − Zti = ln Sti +∆ − ln Sti .

−→ Hence, in this example, Xti+∆ corresponds to the log-return of

Question: What is the expression for the function f in this

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 12 / 41

Recall that the value of the portfolio at t in this example is:

Question: What is the expression for the linearized loss Llin

For this, we need first to compute the partial derivatives of the

The linearized loss Llin

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 14 / 41

Example: A portfolio of one call option

Portfolio consisting of one call option on a stock S with maturity date T

where c is a deterministic function (for the proof, cf. later in

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 15 / 41

Example: A portfolio of one call option

Xt +∆ = (Xt1+∆ , Xt2+∆ , Xt3+∆ )0 = (ln St +∆ −ln St , rt +∆ − rt , σt +∆ −σt )0

Here, the function f equals to the function c.

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 16 / 41

Where do we get the Loss distribution from?

There are different approaches (or methods) used in practice.

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 17 / 41

Idea: A risk measure is a mapping which associates to a loss L a real

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 18 / 41

We will now introduce the notions of risk measure, monetary risk

Miryana Grigorova (Univ. of Leeds) MATH5340 2020/21 19 / 41

What is the financial interpretation of the property of monotonicity?