Gold

• You buy 1 oz of gold today

• Price: USD 1,296
• Quantity: 1
• Total Investment: USD 1,296

Gold Price
1,350.00

Based on price fluctuation: 1,330.00

1,310.00 1,295.25
1,290.00
How much could I lose tomorrow 1,270.00

holding my coin? 1,250.00

1,230.00
1,210.00
1,190.00
1,170.00
1,150.00
VaR (Value at
Risk)
A high level risk
metric for risk
control.

BoC Peru
(7 June 2019)
Content

Delta-Normal
(Parametric)

1. VaR

Non-
Montecarlo

Parametric

Historical

2. Stress
Testing

3. CVaR

4. Backtesting
 Var (Value at Risk)
Invented by JPMorgan in the 1980s, VaR, or Value at Risk, is a way of measuring the
amount of money a bank can expect to lose on its portfolio of tradable assets (eg,
stocks and bonds) if markets plummet. VaR is calculated for a specified period of time
and for a specified level of confidence.

• What is VaR?
Probabilistic method of measuring the Potential Loss in:
Portfolio Value (Investment – Treasury)
Over a given Time Period (1d – 10d)
Given a Distribution of returns:
 Normal Distribution (Delta-Normal)
 Future scenarios (Montecarlo)
 Historical data (last 250 days)
Var (Value at Risk)

• How to interpret a VaR number?

Assume the Risk Officer calculates the daily 1% VaR as $10,000:

It means: “There is a 1% chance that, tomorrow, under normal

circumstances, the portfolio might experience a loss of $10,000 or more.”

Another interpretation: “There is a 99% chance that, tomorrow, under normal

circumstances, the portfolio will experience a loss less than $10,000”

“I can be 99% sure that tomorrow, under normal circumstances, the

maximum potential loss exposition is $10,000”
Delta-Normal (Parametric)
• It assumes that investment returns are normally distributed
A normal distribution is defined by
two parameters:
µ: 0
 σ:1
Perfectly symmetric 50% 50%

Kaplan, FRM. 2019

 Delta-Normal (Parametric)

The percent VaR, mathematically is defined

as:
VaR (X%) = zX%σ
where:
VaR (X%) = the X% probability value at risk

zX% = the critical z-value based on the normal

distribution and the selected X% probability

σ = the standard deviation of daily returns on a

percentage basis

The VaR in dollar basis is:

Kaplan, FRM. 2019

 Delta-Normal (Parametric)
Example:
A risk management officer at a bank is interested in calculating the VaR of an asset. The
asset has a daily standard deviation of returns equal to 1.4% and the asset has a current
value of $5.3 million, calculate the VaR (5%) on both a percentage and dollar basis.

Z-value for a VaR (5%) is −1.65.

VaR (5%) = z5%σ = −1.65(0.014) = −0.0231 = −2.31%

The VaR(5%) on a dollar basis is calculated as follows:

 Delta-Normal (Parametric)
Conversions:

Converting daily VaR to Converting VaR to different

other time bases confidence levels
VaR can be converted from a 1-day basis to a longer
basis

Assume that a risk manager has calculated VaR

VaR(10%)5-days (weekly)  =VaR(10%)1-day = $12,500  = $27,951
VaR(10%)20-days (monthly) = VaR(10%)1-day = $12,500  = $55,902
VaR(10%)125-days  = VaR(10%)1-day = $12,500  =$139,754
at a 95% confidence level to be $16,500. Now
assume the risk manager wants to adjust the
confidence level to 99%. Calculate the VaR at
a 99% confidence level.

VaR(10%)250-days  = VaR(10%)1-day = $12,500  =$197,642

Overall: This method is fast and efficient.

Montecarlo

• The Monte Carlo simulation approach revalues a portfolio for a large

number of risk factor values.
• Time consuming and costly.
• Refers to computer software that generates hundreds, thousands, or
even millions of possible outcomes from the distributions of inputs 


S t  St 1  S t 1 t   t dt 
190.00
185.00
180.00
175.00
170.00
165.00
160.00
155.00
150.00
1 2 3 4 5 6 7 8 9 10 11
Historical

• The easiest way to calculate the VaR.

• Process:
• Accumulate a number of past daily returns
• Rank the returns from highest to lowest
• Identify the lowest 5% of returns

Example: Historical VaR

You have accumulated 100 daily returns for your $10,000,000 portfolio. After ranking
the returns from highest to lowest, you identify the lowest six returns:

–0.11% ; –0.19% ; –0.25% ; –0.34% ; –0.96% ; –1.01%

The lowest five returns represent the 5% lower tail of the "distribution" of 100
historical returns. The fifth lowest return (–0.0019) is the 5% daily VaR. We would say
there is a 5% chance of a daily loss exceeding 0.19%, or $19,000.
Historical

Advantages:

• The model is easy to implement when historical data is readily

available.
• Calculations are simple and can be performed quickly.
• It does not depend on assumptions about the distribution of return.
No need for any parameter estimation.
• Full valuation of portfolio is based on actual prices.
• It is not exposed to model risk.
• There are not different models for equities, bonds, and derivatives.
• It includes all correlations as embedded in market price changes.
Historical

Disadvantages:

• It may not be enough historical data for all assets.

• Only one path of events is used (the actual history), which includes
changes in correlations and volatilities that may have occurred only in
that historical period.
• Time variation of risk in the past may not represent variation in the
future.
• It uses the same weights on all past observations. If an observation
from the distant past is excluded, the VaR might change significantly.
• A small number of actual observations may lead to insufficiently
defined distribution tails.
VaR for BOC Peru
 Stress VaR

• Stressed VaR: A financial institution selects a period of consecutive 12 months when it

sustained material loss as a notable financial stress scenario, and then inputs the
adjusted data extracted from the historical period into the VaR model, so as to
calculate the VaR of the current asset portfolio.

• The financial crisis of 2008 is the scenario selected to assess the Investment
portfolio. Scenario analysis estimates the value of a portfolio based on a "worst case
scenario" and presents the potential extraordinary loss.
CVaR
• The Conditional VaR (CVaR) is a risk evaluation measure that
quantifies the amount of tail risk that has an investment portfolio is
derived through the weighted average of the "extreme" losses in the
tail of the distribution of possible yields, beyond the VaR cut-off
point.
• It is the expected loss among all the losses that are greater than the
VaR.
CVaR

We have 100 daily returns from a portfolio of USD 10 MM. After ordering the
returns from the largest to the smallest, we identify the 6 smallest returns:

-0.11% ; -0.19% ; -0.25% ; -0.34% ; -0.96% ; -1.01%

With a 95% confidence level, the CVaR is the tail VaR, or the average of the
yields below the VaR

Average = (-0.19%) + (-0.25%) + (-0.34%) + (-0.96%) + (-1.01%)

5
CVaR = -0.55% x USD10MM
CVaR = -55,000
 Backtesting

• Back-testing is designed to compare the daily profit and loss data and the VaR data
produced by the internal model. It is an ongoing monitoring and improvement over
the market risk-related internal model.

Today Tomorrow
Recall that the VaR is the
prediction of the maximum VaR (today)
loss that could occur in a
forecast horizon (very short
term, for example, 1 day)

RESULT (tomorrow)

The backtesting is a way to

check if the prediction was VaR (today) RESULT (tomorrow)
effectively fulfilled or not
 Backtesting

VaR Calculated
Imagine a VaR and some
measured results as an absolute Real Result
value. We have 100
comparisons (of 100 days) and
VaR Calculated
a confidence level of 99% Real Result

(Assume that in all cases the VaR

is greater than the actual result)

The fact that the actual losses If the confidence level is 99% it
exceed the VaR is called means that 1 time out of every
EXCEPTION 100, the VaR will not be the
maximum estimated loss.
Backtesting
Number of
breaches in Additional
Area the last 250 capital Action to be taken
observation factor
results

Back test result does not show problems in the Bank's internal
Green area Less than 5 times 0.00 model, so it is not necessary to take actions

5 times 0.40
6 times 0.50
Back test result shows that it may exist problems in the Bank's
7 times 0.65 Internal model, but this conclusion is not completed. In this case,
8 times 0.75 the Bank will analyze the reasons for breaches and it will give a
Yellow area reasonable explanation. If breaches are due to commercial
strategy, the Bank will make moderate adjustments to it. The
improvement of the system or system provider will be discussed,
9 times 0.85 in case breaches are due to model failures.

Back test result shows that the Bank's internal models are likely to
have some problems or the business strategy may go wrong. In
this case, the Bank needs to analyze the reasons for breaches
Red area 10 times or more 1.00 and submit the improvement plan according to specific reasons.

This analysis should be done and communicated to the senior

Management on a quarterly basis.
Xie Xie!

Q&A