Value at Risk
Financial Risk Management
Prof. (Dr.) Swati Sharma
Value at Risk
● With a certain level of confidence, what is the maximum value that
an asset or portfolio may loose over a specified time period
● the “VaR” has three elements:
○ a level of confidence (say, 99%),
○ a time period (a day) and
○ an estimate of loss (expressed either in rupees or percentage terms).
● In general, VaR refers to the amount of money a portfolio is likely
to lose over some predefined period and at a given confidence level
5%
-10MM
Possible Profit/Loss
● Daily VaR;
● N-day VaR;
= Daily VaR*(N^1/2)
Year = 252 working days
Month =22/21 working days
Weekly = 5 working days
COHERENT RISK MEASURES
1. Monotonicity: If a portfolio produces a worse result than another portfolio for
every state of the world, its risk measure should be greater.
2. Translation Invariance: If an amount of cash K is added to a portfolio, its risk
measure should go down by K.
3. Homogeneity: Changing the size of a portfolio by a factor λ while keeping the
relative amounts of different items in the portfolio the same, should result in the
risk measure being multiplied by λ.
4. Subadditivity: The risk measure for two portfolios after they have been merged
should be no greater than the sum of their risk measures before they were merged.
Expected Shortfall (ES/Conditional VaR)
● Overcomes major limitation of VaR measure, i.e., VaR (being a positional measure)
does not communicate anything about returns beyond VaR and their effect on
portfolio value;
● Expected Shortfall, as the name suggest, lets you know the average loss conditioned
to that the loss will be more than a threshold value (VaR). This is also known as
Conditional VaR (CVaR).
● It communicates average size of the losses, for the losses which are greater than VaR
loss.
Methods of VaR calculation
● Historical Simulation Approach
● Monte Carlo Simulation Approach
● Variance-Covariance Approach/ Parametric Approach (Normal, Extreme Value
Theory (EVT), POT, Block Maxima Approaches)
Historical Simulation Approach
● It consists of using historical changes in market rates and prices to
construct a distribution of potential future profits and losses.
● The distribution of profits and losses takes the current portfolio, subjecting
it to actual changes in risk factors experienced in the past N periods (trade-
off regarding N).
● We calculate N historical percentage changes in risk factors, and see how
these changes would affect the portfolio value today.
Steps
1. Obtain historical values of the markets factors for the last N periods
(252 days for instance)
2. Subject the current portfolio to the changes in market factors in the
last N periods, calculating the daily profits and losses that would
occur if comparable daily changes in the market factors are
experienced
3. Order the results and select a loss that is equaled or exceeded 5% of
the time
Monte Carlo Simulation Approach
1. Used when historical data is not sufficiently available.
2. Consists of choosing a (multivariate) statistical distribution that is
believed to adequately capture the possible changes in the risk
factors.
3. The distribution is not necessarily normal.
4. Using this distribution, thousands of risk factor changes are
simulated.
5. Then, the possible losses are calculated using the simulated risk
factors
Variance- covariance Method
1. Based on the assumption that the underlying factors have a multivariate
Normal distribution.
2. Under this assumption, we can compute the distribution of portfolio profits
and losses.
3. Then, standard properties of the normal distribution determine the VAR.
VaR = Mean-standard deviation* Z value
Suppose 2 million is mean for Stock ABC Ltd. (assumption: normally distributed),
SD 1.3 million. VaR @99%, 95%, 90%
Sol: 2-1.3*
