Value at Risk

Value At Risk
Value at risk can be defined as the worst loss that might be expected from holding a security or portfolio over a given period of time (a single day or any other period), given a specified level of probability ( known as the confidence level). VaR is the answer to the following question: What is the maximum loss over a given time period such that there is a low probability, say a 1 percent probability that the actual loss over the given period will be larger? For example, If we say that a position has a daily VaR of Rs. 10 lakh at the 99 percent confidence level, we mean that the realized daily losses from the position will, on average, be higher than Rs. 10 lakh on only one day every 100 trading days.

VaR
Parametric and Non-parametric VaR When VaR is derived from a distribution that is constructed using historical data, it is called nonparametric VaR. If the VaR is derived assuming a particular theoretical distribution of the returns, it is called parametric Var. In this case, historical data are used to estimate the parameters of the assumed distribution function. If a normal distribution is assumed, VaR(H:c) = - V Where is the standard normal variate.

VaR
From 1-Day VaR to 10 Day VaR
One-day VaR is derived from the daily distribution of the portfolio values. However, 10 days is the time horizon set by the regulators for the purpose of reporting regulatory capital. The 10 day VaR can be derived either from the corresponding distribution over a 10-day horizon or the 10-day VaR can be approximated by multiplying the daily VaR by the square root of time (here, 10 days). VaR (10; c) = VaR (1;c) This approximation can be used provided the daily returns are independent and identically distributed (i.i.d.). The result will not hold if the stock returns exhibit mean reversion, are serially correlated, or more generally are not i.i.d.

Uses of VaR
VaR provides a common, consistent and integrated measure of risk across risk factors, instruments, and asset classes leading to greater risk transparency and a consistent treatment of risks across the firm. VaR takes into account the correlations between various risk factors VaR provides an aggregate measure of risk; a single number that is related to the maximum loss that might be incurred on a position, at a given confidence level. The risks taken by the business line can be monitored using limits set in terms of VaR.

Uses of VaR
VaR provides senior management, the board of directors and regulators with a risk measure that they can understand. VaR provides a framework to assess, ex-ante, investments and projects on the basis of their expected risk-adjusted return on capital. A VaR system allows a firm to assess the benefits from portfolio diversification within a line of activity, across businesses(such as equity and fixed-income businesses). VaR has become an internal and external reporting tool.

Calculating VaR
To calculate VaR, we first need to generate the forward distribution of the portfolio values at the risk horizon or equivalently, the distribution of the changes in the value of the portfolio. From this distribution, the mean and the quantiles are calculated. There are three approaches to deriving this distribution: 1. The historical simulation approach. 2. The model building approach 3. The Monte Carlo approach

Historical Simulation Approach

The historical simulation approach to VaR is conceptually simple. First, the changes that have been seen in the relevant market prices and rates (the risk factors) are analyzed over a specified historical period, say, one to four years. The portfolio under examination is then revalued, using changes in the risk factors derived from the historical data, to create the distribution of the portfolio returns from which the VaR of the portfolio can be derived. Each daily simulated change in the value of the portfolio is considered as an observation in the distribution. Three steps are involved:

Historical Simulation Approach

Select a sample of actual daily risk factor changes over a given period of time, say 250 days (i.e. one years worth of trading days). (ii) Apply those daily changes to the current value of the risk factors and revalue the current portfolio as many times as the number of days in the historical sample. (iii) Construct the histogram of portfolio values and identify the VaR that isolates the first percentile of the distribution in the left hand tail, assuming VaR is derived at the 99 percent confidence level. (i)

Example: Historical Simulation

Assume that the current portfolio is composed of 1,00, 000 shares of stock of company and the current price is Rs.26.30 per share Table : Historical Market Values for the Risk Factors over the Last 100 Days -------------------------------------------------------------------------------------------------Day Stock Price (t) Rs. -100 25.00 -99 25.20 -98 24.90 -97 24.80 --------3 26.75 -2 26.10 -1 26.25 0 26.30 --------------------------------------------------------------------------------------------------

Example: Historical Simulation

Simulating Portfolio Values Using Historical Data (Current Value of the Portfolio: Rs. 2.63m)

Scenario

Alternate Price

Change from Current (Rs.2.63 m)

1 26.50 0.020 2 26.00 -0.030 3 26.20 -0.010 . .. 99 26.45 0.015 100 26.35 0.050 -------------------------------------------------------------------------------------------------------------------The last step consists of constructing the histogram of the portfolio returns based on the last 100 days of history, or equivalently sorting the changes in portfolio values to identify the first percentile of the distribution as shown in the following table:

Example: Historical Simulation

Identifying the First Percentile of the Historical Distribution of the Portfolio Return Rank 100 99 98 .. 2 1 Change from Current Value - 0.10 - 0.08 - 0.05 + 0.07 + 0.08

Using the above table, we identify the first percentile as 0.10. In the above example, the estimate of VaR will be updated every day using the most recent 100 days of data

Historical Simulation
Historical simulation requires re-pricing of the position using the historical distribution of the risk factors. Table shows the value of the stock assuming that the successive changes from now onwards are the same as happened over the last 100 days. The change in stock price between day -100 and day -99 is from Rs.25.00 to 25.20. If the current price changes by the same percentage, it should be Rs.26.30 x 25.20/25.00= Rs.26.51 (rounded off to Rs.26.50). Proceeding in this manner 100 alternate stock price scenarios are generated and changes in portfolio value from the current value are calculated.

Weighted Historical Simulation

VaR based on historical simulation assigns equal weight to all the observations. The VaR so calculated is not sufficiently responsive to the most recent information. Weighted HS assigns relatively more weight to the most recent observation and relatively less weight to the observations further in the past. The weights assigned to observations decline exponentially through the past. The weight given to scenario i is:

ni (1 ) 1 n

is assumed to be a number between 0.95 and 0.99

Weighted Historical Simulation

Let weights assigned to observations decline exponentially as we go back in time
Rank observations from worst to best

Starting at worst observation sum weights until the required quantile is reached

Example WHS =0.995

Scenario Number 494
339 349 329 487 227 131

Loss (Rs.000s) 477.841

345.435 282.204 277.041 253.385 217.974 205.256

Weight 0.00528
0.00243 0.00255 0.00231 0.00510 0.00139 0.00086

Cumulative Weight 0.00528

0.00771 0.01027 0.01258 0.01768 0.01906 0.01992

One-day 99% VaR=Rs.282,204

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Volatility Adjusted VaR

In the volatility updating scheme the percentage change observed on day i for a market variable is adjusted for the differences between volatility on day i and current volatility.

Volatility Adjusted Losses

Scenario Number 131 Loss (Rs.000s) 1,082.969

494
227 98 329 339 74

715.512
687.720 661.221 602.968 546.540 492.764

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Bootstrap Method
Suppose there are 500 daily changes Calculate a 95% confidence interval for VaR by sampling 500,000 times with replacement from daily changes to obtain 1000 sets of changes over 500 days Calcuate VaR for each set and calculate a confidence interval This is known as the bootstrap method. Suppose that the 25th largest VaR is Rs.5.3 million and the 975th largest VaR is Rs.8.9 million. The 95% confidence interval for VaR is Rs.5.3 million to Rs.8.9 million
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Historical Simulation Approach

The major attraction of historical simulation is that the method is completely nonparametric and does not depend on any assumption about the distribution of risk factors. We do not need to assume that the returns of the risk factors are normally distributed and independent over time. There is also no need to estimate volatilities and correlations as these are already reflected in the data set. Historical simulation has also no problem accommodating fat tails, since the historical returns already reflect actual synchronous moves in the market across all risk factors.

Historical Simulation Approach

The main drawback of historical simulation is its complete dependence on a particular set of data and thus on the idiosyncrasies of this data set. The underlying assumption is that the past, as captured in the historical data set, is a reliable representation of the future. However, the historical period may cover events such as a market crash or conversely, a period of exceptionally low price volatility, that are unlikely to be repeated in the future. Similarly there may have been structural changes in the market such as the introduction of the Euro at the beginning of 1999. Another practical limitation of historical simulation is data availability. Employing small samples of historical data leaves gaps in the distributions of the risk factors and tends to under represent the occurrence of unlikely but extreme events.