Market Risk and VaR

Financial Risk Management

Risk Management and the Firm
Why Should Firms Manage Risk?

Classic Portfolio Theory

M & M theory

Modern Portfolio Theory

 Types of Costs for a Business

Bankruptcy Cost

Taxes

Capital structure and the cost of capital

Compensation packages
Evidence on Risk Management Practices:

Wharton School surveyed 2000 companies on their risk management

practices.
Does Risk Management Improve Firm
Performance?
Response to Risks
Avoidance:
A business strives to eliminate a particular risk by getting rid of its cause.

Mitigation:
Decreasing the projected final value associated with a risk by lowering
the possibility of the occurrence of the risk.

Acceptance:
In some cases, a business may be forced to accept a risk. This option is
possible if a business entity develops contingencies to mitigate the
impact of the risk, should it occur
 Risk Analysis Process
Identify existing risks:
It is not possible to mitigate all existing risks, prioritization ensures that
those risks that can affect a business significantly are dealt with more
urgently.
Assess the risks
A business should locate the cause of the risks by asking the question,
“What caused such a risk and how could it influence the business?”
Develop an appropriate response
What measures can be taken to prevent the identified risk from
recurring? In addition, what is the best thing to do if it does recur?
Develop preventive mechanisms for identified risks
 Brief Taxonomy of Risks

Market Risk

Liquidity risk

Operational risk

Credit risk

Business risk
Market Risk

Interest rate risk

FX risk

Equity Risk

Commodity Risk
 Value-at-Risk (VaR)
A statistical technique used to measure and quantify the level of
financial risk within a firm or investment portfolio over a specific
time frame.

Value at risk is used by risk managers in order to measure and

control the level of risk which the firm undertakes.

The risk manager's job is to ensure that risks are not taken beyond
the level at which the firm can absorb the losses of a probable worst
outcome.

The VaR is measured either at 95% confidence level or at 99%

confidence level.
 Value at Risk - three variables
1. The amount of potential loss,
2. the probability of that amount of loss,
3. the time frame.

For example, a financial firm may determine that it has a 5% one month
value at risk of $100 million.
a. There is a 5% chance that the firm could lose more than $1000 million in any given
month.
b. There is a 95% chance that in any given month the firm will not suffer a loss of $1000.

Suppose $1000 represents 12% chance of a loss, we say that;

a. There is a 5% chance that the loss will exceed 12%.
b. There is a 95% chance the loss will not exceed 12%.
Practical Uses of VaR

To set a risk target or boundary.

To determine capital requirements (the riskier the activity, the higher the
VaR and the greater the capital requirement).
For disclosing financial instruments and risk.
To assess the risks of different investment opportunities before decisions
are made.
To implement portfolio-wide hedging strategies.
To discourage ‘moral hazard’ excessive risk-taking.
Methods of Computing VaR
Historical Simulation Method
Delta Normal Valuation Method
Monte Carlo Method
Conditional Value-at-Risk (Expected Shortfall)
Portfolio Theory
Back-Testing
Stress-Testing
Scenario Analysis
 Historical Simulation Method

The fundamental assumption of the Historical Simulations methodology

is that you base your results on the past performance of your portfolio
and make the assumption that the past is a good indicator of the near-
future.
Steps

For example, we take the data for last 240 days. Our confidence level is
95%. We compute it is as under:

a. Pick the data for last 240 days.

b. Arrange the data in ascending (descending) order.
c. Take 5% of 240, 240 x 5% = 12
d. Now see the 12th value from top (bottom). (in the return column)
e. Suppose the 12th value from top (bottom) is -.17. It means that there
is a 5% chance that the loss will be more than 17% in a day.
If the confidence level is 99%, 1% of 240 = 2.4

Take the 2nd and 3rd bottom values and then apply:

[2nd bottom value + (3rd value - 2nd value)* 0.4]

Delta Normal Valuation Method

From Normal Distribution critical values table, we can work out

the VaR.

Example: For 95% certainty, we can expect actual return to be

between the range {m - 1 .6 5s , m + 1 .6 5s }
Delta Normal Valuation Method

If we assume m=0, VaR = $V (1.65 s1)

VaR on percentage basis:
Formula: VaR(%) = - zσ (where value of z at 5% is 1.65 and at 1% is 2.31)

VaR on dollar basis:

Formula: VaR($) = - zσ (p) (where p is the value of asset / portfolio)

Example:
A risk management officer at a bank is interested in calculating the VaR of
an asset that he is considering adding to the bank‘s portfolio. If 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.
 Example

Solution:

σ = 1.4%
p= 5.3 million
VaR(%) = - zσ = -1.65(.014) = -.0231 = -2.31%
VaR($) = - zσ (p) = -1.65(.014)(5.3) = -.0122430

Thus, there is a 5% chance that, on a given day, the loss in the value of
asset will exceed from 2.31% or $122,430.
 Example
Mean return = 0 %. Let s1 = 0.02 (per day)

Only 5% of the time will the loss be more than 3.3% (=1.65 x 2%)

VaR of a single asset (Initial Position V0 =$200m in equities)

VaR = V0 (1.65 s1 ) = 200 ( 0.033) = $6.6m

That is “(dollar) VaR is 3.3% of $200m” = $6.6m

VaR is reported as a positive number (even though it’s a loss)
 Delta Normal Valuation Method - Time
Conversion of VaR

VaR, measures the risk of a loss over a period of one day. We can
calculate it for longer periods such as a week, month, quarter or year.

It can be converted simply by multiplying the daily VaR to the required

period.
HINT: (always consider 5 days in a week, 20 days in a month and 240 days in a year)

To calculate multiply the daily value with √n.

 Time Conversion of VaR
VaR(5%)daily = - zσ = -1.65(.014) = -.0231
VaR(5%)weekly = VaR(5%)daily √n = -.0231 x √5 = -.052
VaR(5%)month = VaR(5%)daily √n = -.0231 x √20 = -.10
VaR(5%)quarter = VaR(5%)daily √n = -.0231 x √60 = -.18
VaR(5%)year = VaR(5%)daily √n = -.0231 x √240 = -.358
Or we can calculate it from monthly or quarterly values of VaR.
VaR(5%)quarter = VaR(5%)monthly √n = -.10 x √3 = -.18
VaR(5%)year = VaR(5%)monthly √n = -.10 x √12 = -.358

HINT: in the same way VaR($) can be calculated by simply multiplying the value of VaR% to asset value.
 Portfolio VaR
Portfolio risk, as measured by standard deviation, decreases as the
correlation among assets within the portfolio decreases.

In a similar manner, VaR is affected by the diversification effect that

assets with low correlation bring to the portfolio.

For a two-asset portfolio, VaR(%) is calculated as follows:

VaR(%)portfolio = - z σp
VaR($)portfolio = - z σp(a,b) = (a,b, is the value of portfolio assets)

Whereas:-
𝜎𝑝 = ✓ω1²σ1² + ω2²σ2² +2ω1 ω2 σ1σ2 r1,2
or σp2 =ω1²σ1² + ω2²σ2² +2ω1 ω2 σ1σ2 r1,2
 Example
A fund manager manages a portfolio of two investments: A and B.
Of the portfolio‘s current value of $6 million, A make up 4 million and B, 2 million. The
standard deviation for A is .06 and for B 0.14. Correlation (r1,2) is -0.5. Calculate the VaR
for this portfolio.
 Monte Carlo Method
Monte Carlo Simulations correspond to an algorithm that generates
random numbers that are used to compute a formula .

Drawing random numbers over a large number of times (a few hundred

to a few million depending on the problem at stake) will give a good
indication of what the output of the formula should be.

The only difference from historical simulation is to use the random

numbers instead of continuous series of returns.
Excel sheet
 Expected Shortfall

VaR does not measure loss in the tail, creating a false sense of security.

Expected shortfall (ES) or Conditional tail expectation (CTE):

More conservative measure of downside risk than VaR
• VaR takes the highest return from the worst cases
• ES takes an average return of the worst cases (average of all the losses
below VaR)
 Example
Assume that the sample is of 84 annual returns (1937-2020). The 5th percentile number
comes out 4.2.
This means VaR is between 4th and 5th observations from the bottom (worst returns).
Say, we have the data as -25.03%, -25.69, -33.49%, -41.03%, -45.64%.

VaR= -25.69+.2(-25.03 - (-25.69))

VaR= -25.69+.2(-25.03 + 25.69)= -25.56%

VaR = (4th ret from the bottom) + decimal value of the 5th percentile * (difference in the
5th and 4th ret from the bottom)
Continued…
In continuation of VaR example the ES is calculated by first finding the
equally likely probabilities of the returns.

For example, for last four returns the probability is 4/4.2 and for VaR value
the probability is .2/4.2.

Now take the average of last four returns as (-45.64%-41.03%-33.49%-

25.69%)/4 = -36.4625. (if the worst 5% comes true, we will lose 36.46% on
average)
Lastly E(S) = (-36.4625)*4/4.2 + (-25.56)*.2/4.2= -35.94%.
 Portfolio Theory

The standard deviation of the portfolio return is typically regarded as a

measure of the portfolio’s risk.

Thus, an investor wants a portfolio with a high return but a low

standard deviation. This can be achieved by choosing a portfolio that
maximises the expected return for a portfolio’s standard deviation or
minimises the standard deviation for an expected return.
 Portfolio Theory
Different efficient portfolios will have different risk profiles and thus the
investor must choose a portfolio on the basis of his personal trade-off
between risk and expected return.

For example, a risk-averse investor will choose a safe portfolio with a low
standard deviation and a low expected return, while an investor with a
greater risk appetite will choose a portfolio with a higher
expected return and a higher standard deviation.

Fundamental insight of portfolio theory is that investors can reduce their

risk exposure to an individual asset by holding a diversified portfolio of
assets.
Basic Components of Portfolio Theory
Basic Components of Portfolio Theory
 Beta
The extent to which a new asset contributes to the risk of a portfolio depends on the
correlation or covariance of its return in relation to the returns of the other assets in
the portfolio.

The measure typically used to capture this relationship is beta, which is measured as:

the beta of the market portfolio is 1. Assets that are riskier than the market will have
a beta that is greater than 1 and assets that are less risky than the market will have
betas less than 1.
 Back-Testing
Back-testing is the practice of comparing results of valuation or risk
models to historical experience to evaluate the accuracy of the risk
analysis.

Back-testing uses historic data to assess how well a VaR calculation would
have performed had it been applied in the past.

In other words, if the analysis had been carried out at some point in the
past, would it have provided useful information in the light of what
actually did happen next?

Backtesting does not predict how a VaR calculation will perform in the
future, it does expose the weaknesses since it has been applied to real-
world conditions of the past.
 Back-Testing
Three key objectives of the tests:

■ To test whether the software and database have been properly

installed and implemented.
■ To test whether the modeled probability distribution (VaR) is
consistent with experience.
■ To test whether the modeled P&L matches actual P&L.
 Back-Testing Example
Banks operating under the Basel Committee’s 1996 rules on
trading risk
may be allowed to use their internal VaR models to calculate their
capital
requirements. If they do, they are required to review the accuracy
of
the model-generated estimates by back-testing its results at least
quarterly.

More specifically, the actual trading results over the prior 250
trading days are compared to the bank’s daily VaR and the number
of times that an actual loss exceeded daily VaR is noted.
 Back-Testing Types
The common forms of back-testing include:
a. Unconditional coverage testing – tests if the fraction of
violations obtained for a particular VaR model is significantly
different to a hypothesized fraction.
b. Independence testing – tests if violations occur in clusters.
c. Conditional coverage testing – jointly tests if the VaR violations
are independent and the average number of violations is correct.
d. Shortfall testing – tests whether the amount predicted by the
VaR measure is equal to the expected short-fall risk measure.
e. Left tail testing – tests the VaR model’s ability to capture the left
tail of the distribution where the largest losses will occur.
 Stress-Testing
Stress testing quantifies the loss under extreme outlier events, without
assigning any likelihood to such events or the consequent loss.

The goal is to provide insight on the portfolio behavior that would result
from large moves in key market risk factors:
What if the Fed announced a 50-basis-point increase in interest rates?
Or what if the price of oil doubled?
How would a 30 percent devaluation of the Thai baht affect portfolio profit
and loss (P&L)?

The process of stress testing therefore involves identifying these potential

movements, including which market variables to stress, how much to stress
them by, and what time frame to run the stress analysis over.
 Steps involved in Stress-Testing

1. Determine which variable(s) should be stressed and to what

level(s)
2. Develop assumptions for price correlations within the portfolio
3. Measure the impact of the stress test on the portfolio
4. Develop alternative strategies that can be implemented
5. Evaluate the cost benefit of each alternative strategy
 Types of Stress-Testing

a. Extreme events – can include the recreation of a historic

event, a hypothesized event, and/or a combination of both.
b. Risk factor shocks – conducted by shocking any of the VaR
calculation’s input risk parameters by a user-specified amount.
c. External factor shocks – conducted by shocking any of the VaR
calculation’s parameters with some external shock such as an
index shock, macroeconomic shock etc.
 Scenario Analysis
Scenario analysis typically goes beyond the immediate effects of
predefined market moves and tries to draw out the broader
impact that events may have on the revenue stream and
business.

It is meant to help management understand the impact of

unlikely but catastrophic events, such as major changes in the
external macroeconomic environment that will have an effect
well beyond any immediate impact on the value of a trading
portfolio.
 Scenario Analysis

The crises triggered by the 1998 Russian debt restructuring,

1997 Thai baht devaluation, and

1994 Mexican peso devaluation are historical examples of extreme

situations where the tried-and-tested assumptions made in the past
simply ceased to apply.
 Steps involved in Scenario Analysis

Defining scenarios: The first step is to define a plausible scenario.

Inferring risk factor movements from the scenario: Once a

scenario (or set of scenarios) has been chosen, the second step is to
identify all the relevant risk factors that will be affected by the
scenarios, and the magnitude of the effect that the scenario will
have.
Steps involved in Scenario Analysis

Responding to the results: The next step involves defining the

early warning indicators that would precede the scenario(s) and
the management actions that should be taken in response.
Specific action plans and hedging strategies should be developed
to address any high concentrations or exposures that are
identified.

Reviewing the scenarios periodically: Once a scenario analysis

has been
developed, the methodology should be reviewed periodically
(quarterly, for instance) to see if it needs to be modified due to
changing portfolio or market conditions.