VARNew

The Question Being Asked in VaR
What loss level is such that we are X% confident it will not be exceeded in N business days?
Options, Futures, and Other Derivatives 7th Edition, Copyright John C. Hull 2008
Value at Risk
The Value at Risk measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. Thus, if the VaR on an asset is $ 100 million at a one-week, 95% confidence level, there is a only a 5% chance that the value of the asset will drop more than $ 100 million over any given week
Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008
VaR and Regulatory Capital

(Business Snapshot 20.1, page 452)
Regulators base the capital they require banks to keep on VaR The market-risk capital is k times the 10day 99% VaR where k is at least 3.0
Advantages of VaR
It captures an important aspect of risk in a single number It is easy to understand It asks the simple question: How bad can things get?
Time Horizon
Instead of calculating the 10-day, 99% VaR directly analysts usually calculate a 1-day 99% VaR and assume
10 - day VaR 10 1- day VaR
This is exactly true when portfolio changes on successive days come from independent identically distributed normal distributions
VAR of portfolio
An investor has invested 70000 Rs in asset A and 30000 Rs in asset B. Daily VaR on asset A is 20000 Rs. and on asset B is 8000 Rs. Calculate the daily VaR for overall investment portfolio.
Variance-Covariance Method
Steps: Calculate the value of Mean and Std Dev for the return data series. Portfolio Mean Return,:
Portfolio Std. Dev.:
Percentile value at risk, VAR=|P+ z| V

Where, P= expected return , V = portfolio value , = volatility
An investor has invested 400,000 Rs in an portfolio based on Index XYZ. Calculate the 99 percentile, 10 days VaR for his portfolio by using VarianceCovariance method. Z value is 2.33 and Historical prices for index XYZ are given given as following
10
Date Price
4-1-12 4123
5-1-12 4823
6-1-12 4712
7-1-12 5612
8-1-12 4935
9-1-12 5832
10-1-12 5912
11-1-12 5712
12-1-12 5467
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An investor has invested 20000 Rs in asset A and 80000 Rs in asset B. Daily VaR on asset A is 50000 Rs. and on asset B is 2000 Rs. Calculate the daily VaR for overall investment portfolio. Portfolio VaR = W1 * VaR(A) + W1 * VaR(B)
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Historical Simulation
(See Tables 20.1 and 20.2, page 454-55))
Historical simulations represent the simplest way of estimating the Value at Risk for many portfolios. In this approach, the VaR for a portfolio is estimated by creating a hypothetical time series of returns on that portfolio, obtained by running the portfolio through actual historical data and computing the changes that would have occurred in each period.
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To run a historical simulation, we begin with time series data on each market risk factor, just as we would for the variancecovariance approach. However, we do not use the data to estimate variances and covariances looking forward, since the changes in the portfolio over time yield all the information you need to compute the Value at Risk
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Historical simulation VaR Method
Historical simulation method includes following StepsDefine current portfolio value=1000000 Confidence level- 95% for internal purpose And 99% for credit rating and reporting purpose Forecast horizon is 10 days so we will calculate 10 day- VaR 10 Days-VaR= SQRT (10)*Daily VaR
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Historical Observation Period-I am taking S&P CNX Nifty data from 1 Jan 2007 to 30 Nov 2009 Calculating daily return data Multiply this historical return data with current portfolio value to create hypothetical portfolio Arrange this in descending order and plotting histogram of this data Calculate 95th and 99th percentile values Futures, and Other using hypothetical return Options, data. Derivatives, 7th Edition, Copyright
John C. Hull 2008 16
Historical Simulation continued

Suppose we use m days of historical data Let vi be the value of a variable on day i There are m1 simulation trials The ith trial assumes that the value of the market variable tomorrow (i.e., on day m+1) is
vi vm vi 1
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The Model-Building Approach

The main alternative to historical simulation is to make assumptions about the probability distributions of return on the market variables and calculate the probability distribution of the change in the value of the portfolio analytically This is known as the model building approach or the variance-covariance approach
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Daily Volatilities
In option pricing we measure volatility per year In VaR calculations we measure volatility per day
day
y ear 252
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Daily Volatility continued

Strictly speaking we should define day as the standard deviation of the continuously compounded return in one day In practice we assume that it is the standard deviation of the percentage change in one day
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Microsoft Example (page 456)

We have a position worth $10 million in Microsoft shares The volatility of Microsoft is 2% per day (about 32% per year) We use N=10 and X=99
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Microsoft Example continued

The standard deviation of the change in the portfolio in 1 day is $200,000 The standard deviation of the change in 10 days is
200,000 10 $632,456
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Microsoft Example continued

We assume that the expected change in the value of the portfolio is zero (This is OK for short time periods) We assume that the change in the value of the portfolio is normally distributed Since N(2.33)=0.01, the VaR is
2.33 632,456 $1,473,621
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AT&T Example (page 457)

Consider a position of $5 million in AT&T The daily volatility of AT&T is 1% (approx 16% per year) The S.D per 10 days is

50,000 10 $158,144 The VaR is 158,114 2.33 $368,405
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The Question Being Asked in VaR

VaR and Regulatory Capital

10 - day VaR 10 1- day VaR

Portfolio Std. Dev.:

Percentile value at risk, VAR=|P+ z| V

Where, P= expected return , V = portfolio value , = volatility

Historical simulation VaR Method

Historical Simulation continued

The Model-Building Approach

Daily Volatility continued

Microsoft Example (page 456)

Microsoft Example continued

Microsoft Example continued

2.33 632,456 $1,473,621

AT&T Example (page 457)

50,000 10 $158,144 The VaR is 158,114 2.33 $368,405

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