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By HSIAO-HSIANG HSU
A THESIS PRESENTED TO THE GRADUATE SCHOOL OF THE UNIVERSITY OF FLORIDA IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE IN STATISTICS UNIVERSITY OF FLORIDA
2005
ACKNOWLEDGMENTS I would like to especially thank my advisor, Dr. Alexandre Trindade. He guided me through all the research, and gave me invaluable advice, suggestions and comments. This thesis could never have been done without his help. I also want to thank Dr. Ramon C. Littell and Dr. Ronald Randles for serving on my committee and providing valuable comments. I am also grateful to Yun Zhu for her support and patience. Finally, I would like to thank my families for their unwaving affection and encouragement.
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TABLE OF CONTENTS page ACKNOWLEDGMENTS ................................................................................................. iv LIST OF TABLES............................................................................................................ vii LIST OF FIGURES ......................................................................................................... viii ABSTRACT.........................................................................................................................x CHAPTER 1 2 INTRODUCTION ........................................................................................................1 DEFINITIONS, PROPERTIES AND ESTIMATIONS...............................................4 Definitions ....................................................................................................................4 Definition 2.1: VaR (Value at Risk).....................................................................4 Definition 2.2: CVaR (Conditional Value at Risk) ...............................................4 Definition 2.3: AL distribution (The Asymmetric Laplace distribution) ..............5 Basic Properties ............................................................................................................7 Proposition 2.1: The Coefficient of Skewness ......................................................7 Proposition 2.2: The Coefficient of (excess) Kurtosis .........................................7 Proposition 2.3: The Quantiles ..............................................................................7 Proposition 2.4: VaR and CVaR for the AL distribution ......................................8 Estimations ...................................................................................................................8 Parametric Estimation ...........................................................................................8 Maximum Likelihood Estimation ( MLE ) ....................................................9 Method of Moments Estimation ( MME ) ...................................................11 Semi-parametric Estimation ................................................................................12 Nonparametric Estimation...................................................................................15 3 SIMULATION STUDY .............................................................................................16 Simulation...................................................................................................................16 Comparison.................................................................................................................16 Y~AL(1, 0.8, 1) ...................................................................................................17 Y~AL(0, 1, 1) ......................................................................................................20 Y~AL(1, 1.2, 1) ...................................................................................................21
EMPIRICAL APPLICATIONS .................................................................................26 Data.............................................................................................................................26 Interest Rates .......................................................................................................26 Exchange Rates ...................................................................................................31 Comparison.................................................................................................................34
CONCLUSION...........................................................................................................36
APPENDIX THE PROBABILITIES OF THE MLES OF VAR AND CVAR BEING DEGENERATE..........................................................................................................37 LIST OF REFERENCES...................................................................................................38 BIOGRAPHICAL SKETCH .............................................................................................40
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3-1. Summary of related parameters of Y~AL(0,0.8,1). [n=200, reps=500].....................17 3-2. The MSEs of VaR and CVaR at different confidence levels: =0.9, 0.95 and 0.99 of Y~AL(0, 0.8,1). [n=200, reps=500].............................................................18 3-3. Summary of related parameters ofY~AL(0,1,1). [n=200, reps=500].........................20 3-4. The MSEs of VaR and CVaR at different confidence levels: =0.9, 0.95 and 0.99 of Y~AL(0,1,1). [n=200, reps=500].................................................................21 3-5. Summary of related parameters of Y~(0,1.2,1). [n=200, reps=500] ..........................22 3-6. The MSEs of VaR and CVaR at different confidence levels: =0.9, 0.95 and 0.99 of Y~AL(0,1.2,1). [n=200, reps=500]..............................................................22 4-1. Summary statistics for the interest rates, after taking logarithm conversion..............26 4-2. Summary statistics for the exchange rates, after taking logarithm conversion. .........31
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2-1. VaR and CVaR for the possible losses of a portfolio...................................................5 2-2. Asymmetric Laplace densities with =0, =1, and =2, 1.25, 1, 0.8,0.5.....................6 2-3. The probabilities of the MLEs of VaR and CVaR being degenerate at different confidence levels ..........................................................................................10 nk 2-4. Estimating tail index by plotting log , y( k ) , where n=200 in this case. n The largest value of m, 98, gives a roughly straight line, and the slope of the line is 1.865421. R 2 =0.96....................................................................14 3-1. Histogram of simulated AL (0,0.8,1) data. [n=200, reps=500] ..................................18 3-2. The comparisons of three estimators of Y~AL(0, 0.8,1) at different confidence levels: =0.9, 0.95 and 0.99. [n=200, reps=500] .........................................19 3-3. Histogram of simulated AL (0,1,1) data. [n=200, reps=500] .....................................20 3-4. The comparisons of three estimators of Y~AL(0, 1, 1) at different confidence levels: =0.9, 0.95 and 0.99. [n=200, reps=500] .........................................21 3-5. Histogram of simulated AL (0,1.2,1) data. [n=200, reps=500] ..................................22 3-6. The comparisons of three estimators of Y~AL(0, 1.2, 1) at different confidence levels: =0.9, 0.95 and 0.99. [n=200, reps=500] .........................................23 3-7. Relationships between , the skewness parameter, and MSEs at different confidence levels, =0.9, 0.95 and 0.99. [n=200, reps=500] .......................24 3-8. Relationships among MSEs of VaR and CVaR, the skewness parameter, , and confidence level, for the three different estimators (parametric, semiparametric, and nonparametric) ............................................................25 4-1. Histogram and normal quantile plot of interest rates on 30-year Treasury bonds, sample size = 202.. .......................................................................................28
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4-2. The Q-Q plot of interest rates on 30-year Treasury bonds vs. fitted AL distributions..................................................................................................30 4-3. The difference between CVaR and VaR for 99 quantiles of interest rates on 30 year Treasury bonds (top) and and that of simulated AL distributions (with different simulation seeds)(bottom)....................................................31 4-4. Histogram and normal quantile plot of Taiwan Dollar daily exchange rates, 6/1/00 to 6/7/05, sample size = 1833.......................................................................32 4-5. The Q-Q plot of Taiwan Dollar daily exchange rates, 6/1/00 to 6/7/05 vs. fitted AL distribution .............................................................................................33 4-6. The difference between CVaR and VaR for 99 quantiles of Taiwan Dollar daily exchange rates from 6/1/00 to 6/7/05 and and that of simulated AL distributions (with different simulation seeds).. ...........................................34 4-7. The comparison of three estimators of interest rates on 30-year Treasury bonds, from February 1977 to December 1993, at different confidence levels:=0.9, 0.95 and 0.99. [n=200, reps=500] ..........................................34 4-8. The comparison of three estimators of Taiwan Dollar daily exchange rates,from 6/1/00 to 6/7/05, at different confidence levels: =0.9, 0.95 and 0.99. [n=200, reps=500] ........................................................................................35
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Abstract of Thesis Presented to the Graduate School of the University of Florida in Partial Fulfillment of the Requirements for the Master of Science in Statistics COMPARING ESTIMATORS OF VAR AND CVAR UNDER THE ASYMMETRIC LAPLACE DISTRIBUTION By Hsiao-Hsiang Hsu December 2005 Chair: Alexandre Trindade Major Department: Statistics Assessing the risk of losses in financial markets is an issue of paramount importance. In this thesis, we compare two common estimators of risk, VaR and CVaR, in terms of their mean squared errors (MSEs). Three types of estimators are considered: parametric, under the asymmetric laplace (AL) law; semiparametric by assuming Pareto tails; and ordinary nonparametric estimators, which can be expressed as L-statistics. Parametric and nonparametric estimators have respectively the lowest and highest MSEs. By assessing two types of quantile plots on interest rate and exchange rate data, we determine that the AL distribution provides a plausible fit to these types of data.
CHAPTER 1 INTRODUCTION Risk management has been an integral part of corporate finance, banking, and financial investment for a long time. Indeed, the idea has been dated to at least four decades ago, with Markowitzs pioneering work on portfolio selection [1]. However, the paper did not attract interest until twenty years after it was published. It was the financial crash of 1973-1974 that proved that past good performance was simply a result of bull market and that risk also had to be considered. This resulted in the increasing popularity of Markowitzs ideas on risk, portfolio performance and the benefits of diversification. In the past few years, the growth of financial market and trading activities has prompted new studies investigating reliable risk measurement techniques. The Value-atRisk (VaR) is a most popular measure of risk in either academic research or industry application. This is a dollar measure of the minimum loss that would be expected over a period of time with a given probability. For example, a VaR of one thousand dollars for one day at a probability of 0.05 means that the firm would expect to lose at least $1 thousand in one day 5 percent of the time. Or we can also express this as a probability of 0.95 that a loss will not exceed one thousand dollars. In this way, the VaR becomes a maximum loss with a given confidence level. The most influential contribution in this field has been J.P Morgans RiskMetrics methodology, within which a multivariate normal distribution is employed to model the joint distribution of the assets in a portfolio [2]. However, the VaR approach suffers problems when the return and losses are not normally distributed which is often the case. It underestimates the losses since extreme 1
2 events should happen with equally chance at each day. Obvious explanations for this finding are negative skewness and excess kurtosis in the true distribution of market returns, which cannot be accounted for by using a normal density model as in RiskMetrics. Another risk measure that avoids the problem is Conditional Value at Risk (CVaR). The concept of CVaR was first introduced by Artzuer, Delbaen, Eber, and Heath [3], and formulated as an optimization problem by Rockefellar and Uryasev [4]. CVaR is the conditional mean value of the loss exceeding VaR. It is a straightforward way to avoid serial dependency in the predicted events and thus base ones forecast on the conditional distribution of the portfolio returns given past information. Although CVaR has not become a standard in the finance industry, it is likely to play a major role as it currently does in the insurance industry. Therefore, in the thesis, we consider both of those two measurements for broader application. A correct statistical distribution of financial data is needed first before any proper predicative analysis can be conducted. Although the normal distribution is widely used, it has several disadvantages when applied to financial data. The first potential problem is one of statistical plausibility. The normal assumption is often justified by reference to the central limit theory, but the central limit theory applies only to the central mass of the density function, and not to its extremes. It follows that we can justify normality by reference to the central limit theory only when dealing with more central quantiles and probabilities. When dealing with the extremes, which are often the case in financial data, we should therefore not use the normal to model. Second, most financial returns have excess kurtosis. The empirical fact that the return distributions have fatter tails than
3 normal distribution has been researched since early 1960s when Mandelbrot reported his first findings on stable (Parentian) distributions in finance [5]. Since then, several researchers have observed that practically all financial data have excess kurtosis, which is the leptokurtic phenomena. Thus, using the statistics of normal distributions to characterize the financial market is potentially very hazardous. Since Laplace distributions can account for leptokurtic and skewed data, they are natural candidates to replace normal models and processes. In this thesis, the aim is to compare parametric, semiparametric, and nonparametric estimators of VaR and CVaR random sampling from the Asymmetric Laplace distribution. To do so, we calculate their mean squared error (MSE), a popular criterion for measuring the accuracy of estimators. Broadly speaking, the best estimator should have smallest MSE. The plan of this thesis is as follows. Chapter 2 provides some background to the study by introducing some definitions and propositions related to VaR, CVaR and the Asymmetric Laplace distribution. Chapter 3 compares the parametric, semiparametric, and nonparametric three different estimators of Asymmetric Laplace distribution. Chapter 4 provides empirical analysis by using interest rates and currency exchange rates data. Chapter 5 concludes the article. Additional tables are included in the Appendix A.
CHAPTER 2 DEFINITIONS, PROPERTIES AND ESTIMATIONS Let Y be a continuous real-valued random variable defined on some probability space (, , ), with distribution function F . and density function f(.). Both the first and second moments of Y are finite. Definitions Definition 2.1: VaR (Value at Risk) The VaR refers to a particular amount of money, the maximum amount we are likely to lose over a period of time, at a specific confidence level. If positive values of Y represent losses, the VaR of Y at probability level is defined to be the th quantile of Y.
VaR (Y ) (Y ) = F 1 ( )
bg
(2.1)
Definition 2.2: CVaR (Conditional Value at Risk) The CVaR of Y at probability level ,is the mean of the random variable that results by turncasting Y at and discarding its lower tail. CVaR (Y ) (Y ) = E ( Y Y ) . Expanding on the definition, we obtain (2.2)
Y =
YI bY gh b g E cP bY g = z
1 1 ydF y = 1 1
bg
yf y dy
bg
(2.3)
Y =
bg
1 1
F 1 u du
bg
(2.4)
Figure 2-1. VaR and CVaR for the possible losses of a portfolio
Definition 2.3: AL distribution (The Asymmetric Laplace distribution)
Random variable Y is said to follow an Asymmetric Laplace distribution if there exist location parameter , scale parameter 0, and skewness parameter >0, such that the probability density function of Y is of the form
2 y exp 2 f (y ) = 2 (1 + ) 2 exp y , if , if y y <
(2.5)
(2.6)
6 We denote the distribution of Y by AL(, , ) and write Y~ AL(, , ). The mean of the distribution is given by
= +
Its variance is
1 2
(2.7)
2 =
FG 1 + IJ = K 2 H
2 2
+2 .
(2.8)
+ 2 2 + 2
2 2 + 2 2
(2.9)
and it controls the probability assigned to each side of . If =1, the two probabilities are equal and the distribution is symmetric about . This is the standard Laplace distribution
Figure 2-2. Asymmetric Laplace densities with =0, =1, and =0.5, 1, and 2.
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Basic Properties Proposition 2.1: The Coefficient of Skewness
For a distribution of an random variable Y with a finite third moment and standard deviation greater then zero, the coefficient of skewness is a measure of symmetry that is independent of scale. If Y~ AL(, , ), the coefficient of skewness, 1, is defined by 1 3
2 3 2
1 = 2
FG 1 + IJ H K
2
(2.10)
The coefficient of skewness is nonzero for an AL distribution. As increases within the interval 0, , then the corresponding value of 1 decreases from 2 to 2. Thus, the absolute value of 1 is bounded by two.
Proposition 2.2: The Coefficient of (excess) Kurtosis
b g
For a random variable Y with a finite fourth moment, the coefficient of (excess) kurtosis can be defined as
2 = 6
12 (1 + 2 ) 2 .
2
(2.11)
It is a measure of peakness and of heaviness of the tails. If 2 >0, the distribution is said to be leptokurtic (heavy-tailed). Otherwise, it is said to be platykurtic (light-tailed). The skewness coefficient of the AL distribution is between 3 ( the least value for asymmetric Laplace distribution when =1) and 6 (the largest value attained for the limiting exponential distribution when 0).
Proposition 2.3: The Quantiles
8 + q =
1+ 2 for q 0, 2 , 1 + 2 for q 2 ,1 .
(2.12)
If Y~ AL(, , ), for 0.5, then its standardization X = Y ~ AL 0, ,1 . Since both VaR and CVaR are translation invariant and positively homogenous [7],
VaR (Y ) = + VaR (X ) ,
and
(2.13)
CVaR (Y ) = + CVaR (X ).
(2.14)
Therefore, no generality is lost by focusing on the standard case X ~ AL (0, , 1), provided and are known. VaR and CVaR are then easily obtained.
X =
and
b g
log 1 + 2 1
hb g
(2.15)
X = X +
b g
b g
.
Estimations
(2.16)
We now look at some of the most popular approaches to the estimation of VaR and CVaR.
Parametric Estimation
The parametric approach estimates the risk by fitting probability curves to the data and then inferring the VaR from the fitted curve.
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Maximum Likelihood Estimation ( MLE )
Consider now the most general case of estimating all three parameters. If Y ~ AL(, , ), the maximum likelihood estimators (MLEs) are available in closed form [6]. Define first the functions,
1 ( ) =
1 n + (Yi ) n i= 1 ,
(2.17)
(2.18)
(2.19)
h Y(r) h Y(i) , for i = 1,....., n, = . Provided 1 < r < n, the MLEs of ( , ) are: the MLE of is (r )
= [ 2 (Y(r ) ) 1 ((r ) )]
1 4
( ) ( )
(2.20)
1/ 2