VALUATION & RISK MODEL

PUTTING VAR TO WORK

VAR Approaches

LOCAL FULL REVALUATION

DELTA NORMAL DELTA GAMMA FULL REVALUATION

VAR of a VAR= Delta Approach± Gamma Effect
derivative= As per Tailor’s approximation,
2
Delta* VAR of Risk ∆y=f ‘(x) ∆x +1/2f ‘’(x)( ∆x)
Factor
To be used in the Gamma Effect
rd
case of linear For well-behaved non-linear derivatives,the 3 &
derivatives like higher order terms are negligible.
fwd,futures & So,gamma effect=
2
swaps. 1/2*Gamma*(VAR of risk factor)
Delta-
Normal To be used in the case of non-linear derivatives
VAR of a which are well-behaved like options, non-option
long- embedded bonds.
position is For C+,Gamma effect is in our favour.So,
always VAR=VAR by Delta Approach-Gamma
overstated Effect.
. For C-, Gamma effect is against us.So,
VAR=VAR by Delta Approach+Gamma
Effect.
For P+,Gamma effect is in our favour.So,
VAR=VAR by Delta Approach-Gamma
Effect.
For P-,Gamma effect is against us.So,
VAR=VAR by Delta Approach+Gamma
Effect.
The answers provided by this approach are NOT
100% accurate.
But, since call & put are egs of well-behaved non-
linear derivatives,it gives a reasonable
approximation of the true ans that can be
manufactured by the full-revaluation approach.
CALCULATING VAR OF A BOND POSITION
Delta –Normal Method ( at 99% confidence level)
=z* yield volatility*Modified Duration* Price
(where Modified Duration= Duration/(1+r/m)
Suppose ytm is compounded semi-annually,Higher the frequency of
compounding,higher the volatility and higher the VAR.
Full Revaluation Method
At a 99% confidence level,yield can change by z*yield volatility.
So,new yield=old yield+( z*yield volatility)
Calculate old price(by using old yield) & new price(using new yield).
So, VAR=Old Price-New Price
Got to specify a pricing function (like Black Scholes Model) and
then use SMS( Structured Montecarlo Simulation) to regularly
revalue the position.
To be used in the case of Non-Linear misbehaved series like
option-embedded bonds i.e. callable bonds,puttable bonds &
mortgagebacked securities.Also to be used when we use
cross-partial effects.
Suppose,assume that stock-prices are log-normally distributed.
St+1=Steµ+zσ ( where µ=drift & σ is shock)
Where z=Random draw from the standard normal distribution
& time steps = daily for 100 days.
Now calculate stock price using the above equation for 1
run(i.e. 100 days)& the computer is made to carry out 10,000
runs.
S
22.75
20.19
18.22
Days
Now, out of 10,000 terminal stock prices,arrange them from worst to
best.Thus, the 99% VAR=Loss corresponding to the 100
th
th
observation.Suppose 100 obs=18.64
∴ = 20 − 18.64 = 1.36
NOTE: For a long straddle position i.e. P+ & C+ at the same E,the risk
of this strategy is Share Price not changing too much.So,we cannot
calculate VAR using Delta-Normal Approach.Instead use Full
Revaluation Approach using SMC i.e. assume S follows a certain
µ+zσ
distribution say Log Normal.So, St+1=Ste . Using random draws of
Z,we have various possible (St+1)’s.Value the straddle at each of the
possible Share Prices.Now, arrange straddle values from worst to best
& then slice away the required quartile to get VAR.
Price
Full
Revaluation
637.63 Delta Normal
Method

Delta-Normal gives a higher answer for a long position,since actual VAR

enjoys gamma effect(enjoys convexity which means lower risk/VAR).
Delta-Normal gives a lower answer for a short position,since actual VAR 5% 6.63% Yield
suffers gamma effect(negative convexity i.e. higher risk/VAR)

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