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VaRp(X) = FX (p) ,
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i.e. the pth quantile of FX . (X denotes the profit, X the loss.)
probability density
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Alternative risk measure: Expected shortfall defined as
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ESp(X) = E X X < VaRp ;
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i.e. the average loss when VaR is exceeded. Sp(X) gives 5% probability
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-10 -5 0 5 10
95% ES = 3.3
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-10 -5 0 5 10
n-day log-returns are normally distributed as well: n-day log-returns are still normally distributed:
n
X n
X
Xi N (0, n 2). Xi N (n, n 2).
i=1 i=1
For an autoregressive model of order 1, For an AR(1) model with normal innovations,
i.i.d. s
Xt = Xt1 + t, t N (0, 2), VaR(n) 1+ 1 n
= n 2 .
VaR(1) 1 1 2
1-day and n-day log-returns are normally distributed:
2
Xt N 0, For small values of , n VaR(1) is a good approximation of VaR(n).
1 2
and n
X 2 1 n
Xi N 0, 2
n 2 2
.
i=1
(1 ) 1
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non-normal?
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10dayVaR (99%); empirical
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i.i.d. **
Example: random walk, Xi t8 *
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estimate for the 10-day 99% VaR? *
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(1)
d
(VaR99% denotes the one-day 99% VaR estimate.)
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0.04 0.06 0.08 0.10 0.12 0.14
sqrt(10) * 1dayVaR (99%)
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10-day, t4 innovations
scaled 1-day, t4 innovations
10-day, t8 innovations
the GARCH(1,1) process ( = 0) and its generalization, the
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AR(1)-GARCH(1,1) process:
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(typical parameters: = 0.04, a0 = 3 106, a = 0.05, b = 0.92) Goodness of fit of the scaling rule, depending on different values of
(x axis) for different distributions of the innovations t.
For typical parameters ( = 0.04, t t8), the fit is almost perfect.
c 2004 (R. Kaufmann, ETH Zurich)
14 c 2004 (R. Kaufmann, ETH Zurich)
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GARCH(1,1) vs. Random Walk GARCH(1,1) vs. Random Walk (cont.)
A GARCH(1,1) process If the initial values of the processes (Xa,t) and (X0,t) coincide, then
Stochastic Volatility Model with Jumps Stochastic Volatility Model: Volatility and Returns
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Xt = a t Z t + b J t t ,
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t = t1 ec Yt ,
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i.i.d.
t, Zt, Yt N (0, 1),
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Jt Bernoulli()
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(typical parameters: 0 50 100 150 200 250 0 50 100 150 200 250
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10day VaR
scaled 1day VaR
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Problems when modelling yearly data:
0.0 0.02 0.04 0.06 0.08 0.10 Properties of yearly data are different from those of daily data.
Goodness of fit of the scaling rule, depending on different values of
(x axis).
The scaled 1-day VaR underestimates the 10-day VaR for small
values of . For > 0.04, this changes to an overestimation.
c 2004 (R. Kaufmann, ETH Zurich)
20 c 2004 (R. Kaufmann, ETH Zurich)
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Fix a horizon h < 1 year, for which data can be modelled. Random Walks
Use a scaling rule for the gap between h and 1 year. Autoregressive Processes
GARCH(1,1) Processes
scaling rule
Heavy-tailed Distributions
suitable model
Financial log-data (st)thN can be modelled as a randow walk For an AR(p) model with trend and normal innovations,
process with constant trend and normal innovations:
p
X
i.i.d. st = ai stih + t for t hN,
st = sth + Xt, Xt N (, 2) for t hN. i=1
10-year government bonds, The optimal calibration horizon is about one month. Based on
these data, the square-root-of-time rule (accounting for trends) can
single stocks. be applied for estimating one-year risks.
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The reasons for this good performance are non-trivial. Each
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h = 1 day h = 1 week h = 1 month h = 3 months time rule should not be applied before checking its appropriateness.
h = 1 year
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[Kaufmann, 2004] Kaufmann, R. (2004). 10-rule for stochastic
volatility models. Working Paper.