Assignment I – Individual

a. Differentiate between Value-at-Risk (VaR) and Conditional Value-at-Risk (CVaR),

also known as Expected Shortfall (ES), and discuss their Interpretations.

In financial risk management, VaR and CVaR (ES) are crucial metrics used to
assess the risk associated with investment portfolios.

For this question:

(I) Define VaR and CVaR (ES) (5 marks)

- VaR describes the maximum potential loss over a given time horizon at a particular
confidence level. It determines the probability that an investment's or portfolio's value
will not decline below a given limit.

- CVaR (also called ES) provides information regarding the predicted magnitude of losses
that are projected to occur beyond the VaR threshold. By taking into consideration just
the most extreme cases, it determines the average value of losses exceeding the VaR
limit.

(II) Interpretation of VaR and CVaR (ES) (7 marks)

- Value at Risk (VaR) is a calculation that estimates the highest possible loss, expressed
in terms of money, that an investment or portfolio could face at particular confidence
level over a specific time horizon. For instance, a portfolio with a 95% VaR of $1
million has a 5% probability of suffering losses greater than $1 million within the
provided time frame.

- CvaR (ES) providing information about the expected number of losses beyond the
VaR threshold. It is the average of losses that fall outside of the VaR-indicated level
and happen in the lower part of the distribution. For instance, if the 95% VaR is $1
million, the CVaR may indicate that the average loss in the worst 5% of cases is $1.5
million. It also indicates that there is a 5% possibility of losses going over $1 million,
and that the average loss amount is estimated to be $1.5 million.
 (III) Compare VaR and CVaR (ES) in terms of their approach to measuring risk
and accounting for tail risk. (7 marks)

VaR and CvaR (ES) are commonly used risk factors in finance, they use different
approaches to measuring risk and accounting for tail risk.

- For approach to measuring Risk, the VaR presents a one-point estimate of the
greatest possible loss over a certain time horizon at a particular confidence level. It
represents the point at which losses are unlikely to happen with a certain level of
probability. While the CVaR provides details on the typical size of losses that above
the VaR limit. In more severe cases, it determines the average of losses while taking
the distribution tail into account.

- For the accounting for tail risk. The VaR is focusing on one point in the distribution
(the quantile), commonly at 95%, 99%, or other degrees of confidence. It does not
provide information on the severity of losses that exceed the VaR threshold, even
though it does provide information about the maximum loss. While, The CVaR
directly manages tail risk by taking into account the distribution average loss in the
tail. It covers the whole distribution of losses above the VaR level, giving a more
complete picture of the downside risk.

(IV) Explain how VaR and CVaR (ES) are applied in real-world financial risk
management scenarios. (7 marks)

Value at Risk (VaR) and Conditional Value at Risk (CVaR) are used in real-world
financial risk management scenarios to determine and decrease the risks related to
trading activity, investment portfolios, and different financial instruments.

Portfolio Risk Assessment

- the VaR use to calculate the possible loss in a portfolio's value over a particular time
horizon at a specific confidence level. They can control overall portfolio risk and set
risk limits with the use of this information. However, for CVaR is presenting the
average size of losses beyond the VaR threshold and CVaR offers more information.
This might be useful for risk managers looking for a deeper analysis of potential
losses, especially in any scenarios including tail risk.

Risk Measurement for Trading Desks

- VaR can be utilized by trading desks to establish risk limits on both individual deals
and the portfolio in general. It supports traders and risk managers in realizing how
changes in the market may affect their trading positions. However, for CVaR helps
risk management by taking seriously the currently projected average amount of losses
and also the risk of severe losses (as indicated by VaR). This is especially important
for determining the tail risk connected to trading operations.
 (V) Evaluate the advantages and disadvantages of using VaR and CVaR (ES).
(5 marks)

Advantages Disadvantages
VaR
Simplicity Single Point Estimate
Widespread Adoption Assumption of Normality
Regulatory Recognition Lack of Tail Information
CVaR (ES)
Tail Risk Consideration Complexity
Comprehensive Risk Assessment Interpretation Challenges
Risk Aversion Consideration Data Sensitivity

(VI) Summarize the key differences and implications of VaR and CVaR (ES) in
risk management. (4 marks)

- For the Measurement Approach, the VaR Provides a single point estimate of the
maximum potential loss at a specified confidence level. While the CVaR is beyond
VaR by measuring the average magnitude of losses beyond the VaR threshold.

- Tail Risk Consideration, the VaR Focuses on a specific point in the distribution
(quantile) and may not adequately capture the severity of extreme losses. While the
CVaR (ES) Explicitly addresses tail risk by considering the average loss in the tail of
the distribution, providing insights into the potential severity of extreme events.

(Total 35 marks)
 b. Pricing of FKLI using the Cost of Carry Model

Given: Spot price of KLCI : 1580 points

Futures price of FKLI (3 months) : 1600 points
Risk-free interest rate : 3% per annum
Dividend yield : 2% per annum

Using the cost of carry model:

where: is the futures price

is the spot price
r is the risk-free rate
is the dividend yield
is the Eme to maturity

(I) Calculate the theoretical futures price of FKLI and determine whether it is overpriced
or underpriced. (5 marks)
𝐹 = 𝑆([𝑅 − 𝐷]𝑇)
𝐹 = 1580([0.03 − 0.02]3/12)
𝐹 = 𝟏𝟓𝟖𝟑. 𝟗𝟓𝟒𝟗𝟒𝟐
- Based on the answer, since 3-month FKLI is 1600 point and the Future theoretical
price is 1583.954942, the future is clearly overpriced meaning to say the future
market price is higher than future theoretical price.
(Future market price > Future theoretical price)

(II) Given that FKLI acts as the bellwether instrument, what is the likely direction of the
market? (5 marks)
- The direction of the market is contango meaning to said the future price are higher
than shot price. (Future price > shot price)

(III) As a hedger, should you buy or sell the FKLI? Justify your answer. (5 marks)
- As a hedge to enforce large losses, my decision is to hold onto the FKLI. This means I
won't sell the FKLI until the spot price goes above the future price. The reason behind
this is that selling the FKLI at a lower price could lead to even larger losses.