Numerical on Volatility

1. If daily volatility of a security is 5% how much will be monthly volatility?

1. Volatility = Standard Deviation

2. Variance= (standard Deviation) 2

3. Standard Deviation= √variance

Sol. Daily volatility or standard deviation= 5

Daily variance= 52= 5×5=25

Monthly variance= 25×30=750

Volatility or standard deviation= √750= 27.38

2. If per annum volatility is 30% and number of trading days per annum is 250. How much
will be daily volatility?

Sol. 250 Trading day volatility (standard deviation) = 30% (given)

250 day variance= (30)2=900

Daily variance= 900/250

Daily volatility or standard deviation= √900/250=1.89

 MEASUREMENT OF RISK BASED ON DOWNSIDE POTENTIAL

Downside risk is an estimation of a security's potential loss in value if market conditions

precipitate a decline in that security's price. Depending on the measure used, downside risk
explains a worst-case scenario for an investment and indicates how much the investor stands to
lose. Downside risk measures are considered one-sided tests since the potential for profit is not
considered.

Investors, traders, and analysts use a variety of technical and fundamental metrics to estimate the
likelihood that an investment's value will decline, including historical performance and standard
deviation calculations. In general, many investments that have a greater potential for downside
risk also have an increased potential for positive rewards.

Investors often compare the potential risks associated with a particular investment to possible
rewards. Downside risk is in contrast to upside potential, which is the likelihood that a security's
value will increase.

Some investments have a finite amount of downside risk, while others have infinite risk. The
purchase of a stock, for example, has a finite amount of downside risk bounded by zero. The
investor can lose their entire investment.

Similarly, being long an option either a call or a put has a downside risk limited to the price of
the option's premium, while a short call option position has an unlimited potential downside risk
because there is theoretically no limit to how far a stock can climb. Short puts, on the other hand,
have downside risk limited because the stock or market cannot fall below zero.

TYPES OF POTENTIAL LOSSES

1. Expected loss
2. Unexpected loss
3. Exceptional loss

Expected loss: The expected or EL is a statistical estimate of the average losses. The average
loss is often calculated for credit risk because it represents the statistical mean of losses across a
portfolio and over all possible outcomes.
The actual losses will usually differ from expected loss, since it will be higher or lower.
Expected losses are netted out of revenues by making provisions to hedge the losses.

Unexpected loss: The unexpected loss or UL is the maximum loss that will be exceeded only in
a limited given fraction of all cases. The unexpected loss is the VaR (Value at Risk).

Exceptional Loss: The exceptional losses are those that occur beyond the maximum unexpected
loss. Their likelihood of occurrence is normally very low. In practice the exceptional losses are
obviously difficult to value owing to their very low probability of occurrence.

VALUE AT RISK (VaR)

Value at risk (VaR) is a statistic that quantifies the extent of possible financial losses within a
firm, portfolio, or position over a specific time frame. This metric is most commonly used
by investment and commercial banks to determine the extent and probabilities of potential losses
in their institutional portfolios.

Risk managers use VaR to measure and control the level of risk exposure. One can apply VaR
calculations to specific positions or whole portfolios or use them to measure firm-wide risk
exposure.

Using a firm-wide VaR assessment allows for the determination of the cumulative risks from
aggregated positions held by different trading desks and departments within the institution.
Using the data provided by VaR modeling, financial institutions can determine whether they
have sufficient capital reserves in place to cover losses or whether higher-than-acceptable risks
require them to reduce concentrated holdings.

There are two measure methods of calculating VaR

1. Para metric
2. Non parametric
Parametric
The values needed to calculate VaR
 Investment/ portfolio value
 Expected volatility
 Time horizon
 Confidence Level

Formula for VaR

VaR= Xzσ

X= investment value

Z= value at confidence level

“σ”= standard deviation