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 .

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