EFB344 Risk Management and Derivatives

Tutorial W3: Value-at-Risk 1

Question 1

a. A Finance 1 student has asked you to explain Value-at-Risk (VaR). Write a brief explanation that
this student might understand.

quantifies the potential loss of a financial portfolio over a specified time period and under a
given level of confidence.

b. The same student has said that financial security returns have leptokurtic distributions (i.e. –
high kurtosis). Therefore, calculating VaR using a normal distribution is a waste of time because
the normal distribution does allocate sufficient probability to extreme returns in the tails.
Outline a simple correction to VaR that may appease (make them happier) this student but also
provide two (2) reasons as to why normal VaR is useful.

Question 2

The annual return distributions (distribution, mean and variance) for stock X and Y are specified as

𝑟𝑥 ~𝑁(0.10, 0.04)

𝑟𝑦 ~𝑁(0.15, 0.09)

a. With the bare minimum of calculations (try to do them in your head), outline which stock will
have the lower 1 year value-at-risk (VaR) at the 95% and 99% levels.

b. Calculate the 1 year VaR(95%) and VaR(99%) for each return.

Question 3

It is assumed that volatility scales √𝑡 with time. Why is this?

Question 4

The daily VaR(1,95%) for a stock is -2.00% when the daily mean is assumed to be 0 and returns are
normally distributed. If volatility scales √𝑡 with time, what are the 2-day, 5-day and 10-day VaR(95%)
for this stock? How would these numbers change if the daily mean was known to be 0.1%?

Question 5

Explain the market risk charge (part of Basel II).

Question 6 – Explain the historical Simulation method of calculating VaR

Question 7 – Explain how the confidence level and choice of time horizon affect VaR

Question 8 – You have just started a job in risk management for a trading floor, and someone has
asked you to update the 1 day Riskmetrics EWMA volatility forecast for NAB shares. You don’t have a
full set of historical data, but you know that the forecast for today’s variance was 0.0004 and NAB
shares fell by 4% today.

a. Do you have enough information to forecast tomorrow’s volatility (standard deviation)? If

yes, what is the forecast?

b. If NAB shares go up by 3% tomorrow, what will be the following days volatility forecast?

Question 9 – A Company using the EWMA model for forecasting volatility. It decides to change the
parameter lambda from 0.94 to 0.85. Explain the likely impact on the forecasts.