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Quantitative Risk Management

Hoàng Đức Mạnh & Đào Bùi Kiên Trung

Khoa Toán Kinh tế

Trường Đại học Kinh tế Quốc dân

January 24, 2022

Hoàng Đức Mạnh & Đào Bùi Kiên Trung Quantitative Risk Management 1
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CHAPTER 2. RISK FACTORS AND QUANTITATIVE ANALYSIS

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 OUTLINE
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Risk factors
Mapping of risks
Extreme value
Order statistics
Bootstrapped historical simulation

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 RISK FACTORS
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General Definitions:
We represent the uncertainty about future states of the world by a
probability space (Ω, F, P)
Consider a given portfolio such as a collection of stocks or bonds, a
book of derivatives, a collection of risky loans or even a financial
institution’s overall position in risky assets.
We denote the value of this portfolio at time s by V (s) and assume
that the r.v V (s) is observable at time s.

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General Definitions:
The profit&loss of the portfolio over the period [s, s + ∆] is given by

P&L[s,s+∆] = V (s + ∆) − V (s)

The loss of the portfolio over the period [s, s + ∆] is given by

L[s,s+∆] = −(V (s + ∆) − V (s))

Examples:
P&Lt = Pt + Dt − Pt−1
Lt = −(Pt + Dt − Pt−1 ).
While L[s,s+∆] is assumed to be observable at time s + ∆, it is
typically random from the viewpoint of time s. The distribution of
L[s,s+∆] is termed the loss distribution.
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General Definitions:
Following standard risk-management practice the value Vt is modelled
as a function of time and a d-dimensional random vector
Zt = (Zt,1 , ..., Zt,d ) of risk factors, i.e. we have the representation

Vt = f (t, Zt ),

for some measurable function f . Risk factors are usually assumed to

be observable so that Zt is known at time t.
The choice of the risk factors and of f is of course a modelling issue
and depends on the portfolio at hand and on the desired level of
precision. Frequently used risk factors are logarithmic prices of
financial assets, yields and logarithmic exchange rates. A
representation of the portfolio value in this form is termed a mapping
of risks.
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General Definitions:
It will be convenient to define the series of risk-factor changes
(Xt )t∈N by Xt := Zt − Zt−1 ; the portfolio loss can be written as
Lt+1 := l[t] (Xt+1 ) = −(f (t + 1, Zt + Xt+1 )) − f (t, Zt )) (1)
Since Zt is known at time t, the loss distribution is determined by the
distribution of the risk-factor change Xt+1 ; the loss operator
l[t] : R d −→ R, which maps risk-factor changes into losses.
If f is differentiable, we consider a first-order approximation L∆
t+1 of
the loss in (1) of the form
d
L∆
t+1 := −(f (t, Zt ) + fzi (t, Zt )xi ) (2)
X

i=1

The first-order approximation is convenient as it allows us to

represent the loss as a linear function of the risk-factor changes.
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Conditional and Unconditional Loss Distribution:

Now fix a point in time t (current time), and denote by Ft the sigma
field representing the publicly available information at time t.
Typically, Ft = σ(Xs : s ≤ t), the sigma field generated by past and
present risk-factor changes, often called the history, up to and
including time t.
Denote by FXt+1 |Ft the conditional distribution of Xt+1 given current
information Ft .
FXt+1 |Ft is not equal to the stationary distribution FX . On the other
hand, if (Xt )t∈N is an independent and identically distributed (iid)
series, we obviously have FXt+1 |Ft = FX .

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Conditional and Unconditional Loss Distribution:

The conditional loss distribution is defined as the distribution of the
loss operator l[t] (.) under FXt+1 |Ft :

FLt+1 |Ft (l) = P(l[t] (Xt+1 ) ≤ l|Ft ) = P(Lt+1 ≤ l|Ft ), l ∈ R

The unconditional loss-distribution FLt+1 is defined as the distribution

of l[t] (.) under the stationary distribution FX of risk-factor changes.
Risk-management techniques based on the conditional loss
distribution are often termed conditional or dynamic risk
management; techniques based on the unconditional loss distribution
are often referred to as static risk management.

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Mapping of Risks: Some Examples: Example 1 (stock portfolio):

Consider a fixed portfolio of d stocks and denote by λi the number of
shares of stock i in the portfolio at time t. The price process of stock
i is denoted by (St,i )t∈N . Following standard practice in finance and
risk management we use logarithmic prices as risk factors, i.e. we
take:
Zt,i := lnSt,i , 1 ≤ i ≤ d

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Mapping of Risks: Some Examples: Example 1 (stock portfolio):

The risk-factor changes Xt+1,i = lnSt+1,i − lnSt,i then correspond to
the log-returns of the stocks in the portfolio.
Pd
We have Vt = i=1 λi exp(Zt,i ) and
d
Lt+1 = −(Vt+1 − Vt ) = − λi St,i (exp(Xt+1,i − 1))
X

i=1

The linearized loss L∆

t+1 is then given by

d d
L∆ λi St,i Xt+1,i = −Vt wt,i Xt+1,i
X X
t+1 = −
i=1 i=1

λi St,i
where the weight wt,i := gives the proportion of the portfolio
Vt
value invested in stock i at time t.
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Mapping of Risks: Some Examples: Example 2 (European call option):

We now consider a simple example of a portfolio of derivative
securities, namely a standard European call on a non-dividendpaying
stock S with maturity date T and exercise price K . We use the
Black–Scholes option-pricing formula for the valuation of our
portfolio. Define the function C by

C(s, S; r , σ, K , T ) := SΦ(d1 ) − Ke −r(T −s) Φ(d2 )

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 RISK FACTORS
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Mapping of Risks: Some Examples: Example 2 (European call option):

we take Zt = (lnSt , rt , σt ) as the vector of risk factors. The
risk-factor changes are given by

Xt+1 = (lnSt+1 − lnSt , rt+1 − rt , σt+1 − σt )

The linearized loss is given by

L∆
t+1 = −(Cs ∆ + Cs St Xt+1 + Cr Xt+1 + Cσ Xt+1 ),

where the subscripts denote partial derivatives.

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Mapping of Risks: Some Examples: Example 2 (European call option):

The derivatives of the Black–Scholes optionpricing function are often
referred to as the Greeks:
CS (the partial derivative with respect to the stock price S) is called
the delta of the option;
Cs (the partial derivative with respect to calendar time s) is called the
theta of the option;
Cr (the partial derivative with respect to the interest rate r ) is called
the rho of the option;
Cσ (the partial derivative with respect to volatility �) is called the vega
of the option.

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 EXTREME VALUE
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Approach: Block Maxima method, Peak-Over-Threshold Method

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 EXTREME VALUE
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Extreme Value Theory-EVT: Generalised extreme-value -GEV

Consider a sample of size n drawn from F (x), and let the maximum
of this sample be Mn . Under relatively general conditions, the
distribution of extremes (i.e., Mn ) converges to the following GEV
distribution:
−1

x − µ ξ i

Hξ,µ,σ (x) = exp h − 1 + : ξ 6= 0
 h 

ξ
 x − σµ i
exp − exp :ξ=0



σ
and F is said to be in the maximum domain of attraction of H,
written F ∈ MDA(H).

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Extreme Value Theory-EVT:

The first two are µ, the location parameter of the limiting
distribution, which is a measure of the central tendency of Mn , and σ,
the scale parameter of the limiting distribution, which is a measure of
the dispersion of Mn .
The third parameter, ξ, the tail index, gives an indication of the
shape (or heaviness) of the tail of the limiting distribution. The GEV
has three special cases:
If ξ > 0, the GEV becomes the Frechet distribution. This case is
particularly useful for financial returns because they are typically
heavy-tailed.
If ξ = 0, the GEV becomes the Gumbel distribution. These are
relatively light tails such as those we would get with normal or
lognormal distributions.
If ξ < 0, the GEV becomes the Weibull distribution, corresponding to
the case where F(x) has lighter than normal tails.
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The Frechet case. The distributions that lead to the Frechet limit
Hξ,µ,σ (x) for ξ > 0 have a particularly elegant characterization involving
slowly varying or regularly varying functions.
A slowly varying function: A positive, Lebesgue-measurable function
L on (0, ∞) is slowly varying at ∞ if
L(tx)
lim = 1, t > 0.
x→∞ L(x)
A regularly varying function: A positive, Lebesgue-measurable
function h on (0, ∞) is regularly varying at ∞ with index ρ ∈ R if
h(tx)
lim = t ρ , t > 0.
x→∞ h(x)

Frechet MDA, Gnedenko: for ξ > 0,

F ∈ MDA(H) ⇐⇒ F (x) = x −1/ξ L(x),
for some function L slowly varying at ∞.
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The Block Maxima Method

Fitting the GEV distribution Hξ,µ,σ (x) to data on the n-block
maximum.
We denote the block maximum of the jth block by Mnj , so our data
are Mn1 , ..., Mnm . The GEV distribution can be fitted using various
methods, including maximum likelihood.

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Return levels and stress losses:

Let H denote the df of the true distribution of the n-block maximum.
The k n-block return level is rn,k = q1−1/k (H), i.e. the
(1 − 1/k)-quantile of H.
For example, the 10-tradingyear return level r260,10 is that level
which is exceeded in one out of every 10 years on average.
Using our fitted model we would estimate a return level by

1 σ̂  1 −ξ̂
r̂n,k = H −1 1− − ln(1 − ) −1
 
= µ̂ +
ξ̂,µ̂,σ̂ k ξˆ k

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Generalised extreme-value-GEV:
Example (Frechet): with parameters are
µ = 2%, σ = 0.7%, ξ = 0.3%, we have (1 − 1/k)-quantile of H.

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The peaks-over-threshold-POT:
The application of EVT to the distribution of excess losses over a
(high) threshold, this gives rise to the peaks-over-threshold or
generalised Pareto approach.
If X is a random iid loss with distribution function F (x), and u is a
threshold value of X , we can define the distribution of excess losses
over our threshold u as:
F (x + u) − F (u)
Fu (x) = P(X − u ≤ x|X > u) =
1 − F (u)

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The peaks-over-threshold -POT

However, as u gets large, the GnedenkoPickands-Balkema-deHaan
(GPBdH) theorem states that the distribution Fu(x) converges to a
generalised Pareto distribution:
1

ξx − ξ


1 − (1 + ) : ξ 6= 0


Gξ,β (x) = β
−x
1 − exp( :ξ=0

)


β

This distribution has only two parameters: a positive scale parameter,

β, and a shape or tail index parameter, ξ, that can be positive, zero
or negative.

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The peaks-over-threshold -POT: Mean excess function

The mean excess function of an rv X with finite mean is given by

e(u) = E (X − u|X > u)

The mean excess function of the GPD:

β + ξu
e(u) =
1−ξ

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The peaks-over-threshold -POT: Fitting the GP distribution:

Given loss data X1 , ..., Xn from F , a random number Nu will exceed
our threshold u; it will be convenient to relabel these data
X1∗ , ..., XN∗ u . For each of these exceedances we calculate the amount
Yj = Xj∗ − u of the excess loss.
There are various ways of fitting the GPD including maximum
likelihood (ML) and probability-weighted moments (PWM).

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The peaks-over-threshold -POT: Setting a threshold

Rule of thumb: One way to approach setting a threshold is by using a
rule of thumb to choose the k largest observations and modeling.
Commonly used is the 90th percentile, but others have also been
√
proposed, such as k = n.
Graphical approach: Sample mean excess plot; Parameter Stability
Plot.

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The peaks-over-threshold -POT: Sample mean excess plot

For positive-valued loss data X1 , ..., Xn we define the sample mean
excess function to be an empirical estimator of the mean excess
function Pn
(X − v)IXi >v
en (v) = i=1 Pn i
i=1 IXi >v
If the data support a GPD model over a high threshold then mef
suggests that this plot should become increasingly “linear” for higher
values of v.
If we do see visual evidence that the mean excess plot becomes linear,
then we might select as our threshold u a value towards the beginning
of the linear section of the plot.

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The peaks-over-threshold -POT:

We have:
F (x) = (1 − F (u))Gξ,β (x − u) + F (u)
The most natural estimator is the observed proportion of
n − Nu
below-threshold observations, , then:
n
1
Nu h  x − u i−
F (x) = 1 − 1+ξ ξ
n β

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The peaks-over-threshold -POT: a high quantile of the underlying

distribution: For F (u) ≤ α, we have

β hh n i−ξ
qα (F ) = u + −1
i
(1 − α)
ξ Nu

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The peaks-over-threshold -POT:

Example: Suppose we have our parameters (%):
Nu
β = 0.8, ξ = 0.15, u = 2 and = 4, then F (x), qα (F )?
n

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Some refinements to EV approaches:

Conditional EV
Dealing with dependent (or non-iid) data
Multivariate EVT.

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 ORDER STATISTICS
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The theory of order statistics is very useful for risk measurement

because it gives us a practical and accurate means of estimating the
distribution function for a risk measure.
Using Order Statistics to Estimate Confidence Intervals for risk
measures.

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 ORDER STATISTICS
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Suppose we have x1 , x2 , ..., xn observations from some distribution (or

cumulative density) function F (x) with r th order statistic x(r) and
where
x(1) ≤ x(2) ≤ · · · ≤ x(n)
The probability that j of our n observations do not exceed a fixed
value x obeys the binomial distribution

P(j observations ≤ x) = Cnj [F (x)]j [1 − F (x)]n−j

Hence, the probability that at least r observations in the sample do

not exceed x is also a binomial
n
Gr (x) = Cnj [F (x)]j [1 − F (x)]n−j
X

j=r

Gr (x)is the distribution function of our order statistic.

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 BOOTSTRAPPED HISTORICAL SIMULATION
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Bootstrapping presents a simple but powerful improvement over basic

HS to estimate risk measures.
A bootstrap procedure involves resampling from our existing data set
with replacement.
We start with a given original sample of size n.
We draw a new random sample of the same size from this original
sample, “returing” each chosen observation back in the sampling pool
after it has been drawn.
Sampling with replacement implies that some observations get chosen
more than one, and others don’t get chosen at all.

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The resampling process is repeated many times over, resulting in a set

of resample parameter estimates.
In the end, the average of all the resample parameter estimates gives
us the final bootstrap estimate of the parameter.

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 BOOTSTRAPPED HISTORICAL SIMULATION
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