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# Value at Risk

A Presentation for Banking and Financial Markets Lecture Syed Hassan Talal - F09MB004

Say Hi to VAR

Definition: ± Value at Risk is an estimate of the worst possible loss an investment could realize over a given time horizon, under normal market conditions (defined by a given level of confidence). ± To estimate Value at Risk a confidence level must be specified.

Abnormal market conditions ± the returns that account for the other 5% of the possible outcomes.Say µHi¶ to VAR 5% 95% Investment returns Choice of confidence level ± 95% Normal market conditions ± the returns that account for 95% of the distribution of possible outcomes. .

Point of View! ³an attempt to provide a single number for senior management summarizing the total risk in a portfolio of assets´ ± Hull. with a given degree of confidence. PWOQF . of how much one can lose from one¶s portfolio over a given time horizon´ ± Wilmott. OF&OD ³an estimate.

. Measure of Total Risk) rather than Systematic (or Non-Diversifiable Risk) measured by Beta. VaR translates portfolio volatility into a dollar value.Say Hi to VAR VaR is a measure of risk based on a probability of loss and a specific time horizon.

Calculations VaR can be calculated by using 3 different methodss ± Historical Simulation ± Variance Co Variance ± Monte Carlo Simulation .

Historical Simulation Easiest of All Works best on Stand alone Stock Easy to Compute Easy to Explain Based on Historical Returns .

±HISTORY Repeats Itself ! . from risk¶s perspective.Calculation Algorithm Step 1: Get all the historical returns of the stock Step 2: Arrange them from Worst to BEST Step 3: Assume that.

Lets Do it !!! Source : [Investopedia] QQQ Ticker results .

. we are 95% confident that our worst daily loss will not exceed $4 ($100 x -4%).Lets Do it !!! Source : [Investopedia] QQQ Ticker results With 95% confidence. If we invest $100. we expect that our worst daily loss will not exceed 4%.

Variance Co-Variance Method Based for the Portfolios Implementation is protfolio dependent Short Term Portfolio Market to Market Value Corresponds to the relationship between the stocks in the portfolio .

Note: Technically. Step 3: Compute Value at Risk from sample estimates of W and Q. etc. 95%. Note: It is possible to realize a loss greater than $18. ± 90%.000. Step 2: Choose a level of confidence. log stock returns are ³more likely´ to be normally distributed.Calculation Algorithm Step 1: Transform simple monthly stock returns into continuously compounded stock returns. ± Banks are required to report Value at Risk estimated with a 99% level of confidence to determine regulatory capital requirements. 99%.000. the largest likely loss in the household industry over the next month under normal market conditions with a 95% level of confidence is: $18. ± For example. .

Previous example. Source [Investopedia] .Lets Do It !!! QQQ.

Lets Do It !!! QQQ. Source [Investopedia] . Previous example.

Previous example. Source [Investopedia] .Lets Do It!!! QQQ.

Portfolio Source :[ Options.Lets Do It One more time ! Real time Example. John C. Hull. Futures & Derivatives. 2005] We have a position worth $10 million in Microsoft shares The volatility of Microsoft is 2% per day (about 32% per year) (2*(252^1/2)) We use N=10 and X=99 .

Futures & Derivatives. John C.456 . 2005] The standard deviation of the change in the portfolio in 1 day is $200. Hull.000 The standard deviation of the change in 10 days is 200. Portfolio Source :[ Options.000 10 ! $632.Lets Do It One more time ! Real time Example.

33 v 632. Hull. the VaR is 2.621 .Lets Do It One more time ! Real time Example. Futures & Derivatives.473. Portfolio Source :[ Options.456 $1.33)=0.01. 2005] We assume that the expected change in the value of the portfolio is zero (This is OK for short time periods) We assume that the change in the value of the portfolio is normally distributed Since N( 2. John C.

Lets Do It One more time ! Real time Example. John C.000 The S. 2005] Consider a position of $5 million in AT&T The daily volatility of AT&T is 1% (approx 16% per year).D. Futures & Derivatives.D per 10 days is The VaR is 50. S. per day is 50. Hull.114 v 2. Portfolio Source :[ Options.33 ! $368.405 .144 158.000 10 ! $158.

Hull.D per 10 days is The VaR is 50. 2005] Consider a position of $5 million in AT&T The daily volatility of AT&T is 1% (approx 16% per year). Portfolio Source :[ Options.33 ! $368.144 158. Futures & Derivatives. per day is 50.000 10 ! $158.D. John C.Lets Do It One more time ! Real time Example.405 .000 The S. S.114 v 2.

Monte Carlo Simulation Toughest Method Based upon RANDOM Assumptions More tough to explain than to implement Black Box of random assumptions .

Monte Carlo Simulation Toughest Method Based upon RANDOM Assumptions More tough to explain than to implement Black Box of random assumptions Best used for portfolios containing multiple instruments Lengthy Calculations .

A Glimpse! And many more !!! .

VaR is useful for monitoring and controlling risk within the portfolio. VaR is an easy number to understand and explain to clients. VaR translates portfolio volatility into a dollar value.VAR is so USEFUL VaR provides an measure of total risk. .

. and options. bonds..) As a tool. swaps.VAR is so USEFUL VaR can measure the risk of many types of financial securities (i. off-balancesheet derivatives such as futures.e. forwards. and etc. stocks. foreign exchange. commodities. VaR is very useful for comparing a portfolio with the market portfolio (S&P500).

as opposed to the other measurements of risk in the financial industry such as: beta and standard deviation. . Value at Risk is a dollar value risk measure.Conclusion Value at Risk can be used as a stand alone risk measure or be applied to a portfolio of assets.

In the end Does it Really Matter? Options and Option ± Like Instruments¶ Risks Implementation and Explanation CASH FLOW Scenario Analysis Data Gathering Time Horizon .

ALTERNATE OPTIONS AVAILABLE? Sensitivity Analysis Cash Flow at Risk .