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# CHAPTER 20 Value at Risk

Practice Questions
Problem 20.8. A company uses an EWMA model for forecasting volatility. It decides to change the parameter from 0.95 to 0.85. Explain the li ely impact on the forecasts.
2 Reducing from 0.95 to 0.85 means that more weight is put on recent observations of ui and less weight is given to older observations. Volatilities calculated with = 0.85 will react more quickl to new information and will !bounce around" much more than volatilities calculated with = 0.95 .

Problem 20.9. Explain the difference !et"een value at ris and expected shortfall. Value at risk is the loss that is e#pected to be e#ceeded \$%00 # &\$ of the time in % da s for specified parameter values' # and % . (#pected shortfall is the e#pected loss conditional that the loss is greater than the Value at Risk. Problem 20.10. &onsider a position consisting of a '(00)000 investment in asset A and a '(00)000 investment in asset *. Assume that the daily volatilities of !oth assets are (\$ and that the coefficient of correlation !et"een their returns is 0.+. What is the 5,day 99\$ value at ris for the portfolio)he standard deviation of the dail change in the investment in each asset is *%'000. )he variance of the portfolio+s dail change is %, 0002 + %, 0002 + 2 0., %, 000 %, 000 = 2, -00, 000 )he standard deviation of the portfolio+s dail change is the square root of this or *%'-%2..5. )he standard deviation of the 5/da change is %, -%2..5 5 = ',, -05.55 0rom the tables of % \$ x& we see that % \$2.,,& = 0.0% . )his means that %1 of a normal distribution lies more than 2.,, standard deviations below the mean. )he 5/da 99 percent value at risk is therefore 2.,, ,, -05.55 = '8, .00.9, . Problem 20.11. .he volatility of a certain mar et varia!le is +0\$ per annum. &alculate a 99\$ confidence interval for the si/e of the percentage daily change in the varia!le. )he volatilit per da is ,0 / 252 = %.89\$ . )here is a 991 chance that a normall distributed variable will be within 2.52 standard deviations. 3e are therefore 991 confident that the dail change will be less than 2.52 %.89 = ..8-\$ .

Problem 20.12. Explain ho" an interest rate s"ap is mapped into a portfolio of /ero,coupon !onds "ith standard maturities for the purposes of a 0a1 calculation. 3hen a final e#change of principal is added in' the floating side is equivalent a 4ero/coupon bond with a maturit date equal to the date of the ne#t pa ment. )he fi#ed side is a coupon/ bearing bond' which is equivalent to a portfolio of 4ero/coupon bonds. )he swap can therefore be mapped into long and short positions in 4ero/coupon bonds with maturit dates corresponding to the pa ment dates. (ach of the 4ero/coupon bonds can then be mapped into positions in the ad5acent standard/maturit 4ero/coupon bonds. 6ne wa of doing this is described in the 7ppendi# to 8hapter 20. Problem 20.13. Explain "hy the linear model can provide only approximate estimates of 0a1 for a portfolio containing options. )he change in the value of an option is not linearl related to the percentage change in the value of the underl ing variable. )he linear model assumes that the change in the value of a portfolio is linearl related to percentage changes in the underl ing variables. 9t is therefore onl an appro#imation for a portfolio containing options. Problem 20.1 . 0erify that the 0.+,year /ero,coupon !ond in the cash,flo" mapping example in the Appendix at the end of this chapter is mapped into a '+2)+92 position in a three,month !ond and a '(()29+ position in a six,month !ond. )he 0.,/ ear cash flow is mapped into a ,/month 4ero/coupon bond and a -/month 4ero/ coupon bond. )he 0.25 and 0.50 ear rates are 5.50 and -.00 respectivel . :inear interpolation gives the 0.,0/ ear rate as 5.-01. )he present value of *50'000 received at time 0., ears is 50, 000 = .9,%89.,2 %.05-0.,0 )he volatilit of 0.25/ ear and 0.50/ ear 4ero/coupon bonds are 0.0-1 and 0.%01 per da respectivel . )he interpolated volatilit of a 0.,0/ ear 4ero/coupon bond is therefore 0.0-81 per da . 7ssume that " of the value of the 0.,0/ ear cash flow gets allocated to a ,/month 4ero/ coupon bond and % " to a si#/month 4ero coupon bond. )o match variances we must have 0.000-82 = 0.000-2 "2 + 0.00%2 \$% "& 2 + 2 0.9 0.000- 0.00%"\$% "& or 0.28"2 0.92 " + 0.5,2- = 0 ;sing the formula for the solution to a quadratic equation

0.92 + 0.922 . 0.28 0.5,2"= = 0.2-0259 2 0.28 this means that a value of 0.2-0259 .9,%89.,2 = ',2, ,92 is allocated to the three/month bond and a value of 0.2,92.% .9,%89.,2 = '%%, 29, is allocated to the si#/month bond. )he 0.,/ ear cash flow is therefore equivalent to a position of *,2',92 in a ,/month 4ero/coupon bond and a position of *%%'29, in a -/month 4ero/coupon bond. )his is consistent with the results in the 7ppendi# to 8hapter 20.

Problem 20.1!. 3uppose that the 5,year and 2,year rates are 4\$ and 2\$) respectively 5!oth expressed "ith annual compounding6) the daily volatility of a 5,year /ero,coupon !ond is 0.5\$) and the daily volatility of a 2,year /ero,coupon !ond is 0.58\$. .he correlation !et"een daily returns on the t"o !onds is 0.4. Map a cash flo" of '()000 received at time 4.5 years into a position in a 5,year !ond and a position in a 2,year !ond using the approach in the Appendix at the end of this chapter. What cash flo"s in 5 and 2 years are e7uivalent to the 4.5,year cash flo")he -.5/ ear cash flow is mapped into a 5/ ear 4ero/coupon bond and a 2/ ear 4ero/coupon bond. )he 5/ ear and 2/ ear rates are -1 and 21 respectivel . :inear interpolation gives the -.5/ ear rate as -.251. )he present value of *%'000 received at time -.5 ears is %, 000 = -5..05 %.0-25-.5 )he volatilit of 5/ ear and 2/ ear 4ero/coupon bonds are 0.501 and 0.581 per da respectivel . )he interpolated volatilit of a -.5/ ear 4ero/coupon bond is therefore 0.5-1 per da . 7ssume that " of the value of the -.5/ ear cash flow gets allocated to a 5/ ear 4ero/coupon bond and % " to a 2/ ear 4ero coupon bond. )o match variances we must have .5-2 = .502 "2 + .582 \$% "& 2 + 2 0.- .50 .58"\$% "& or .2,8. "2 .,2.8" + .0228 = 0 ;sing the formula for the solution to a quadratic equation

.,2.8 .,2.82 . .2,8. .0228 "= = 0.02.2., 2 .2,8. this means that a value of 0.02.2., -5..05 = '.8.5- is allocated to the 5/ ear bond and a value of 0.925252 -5..05 = '-05..9 is allocated to the 2/ ear bond. )he -.5/ ear cash flow is therefore equivalent to a position of *.8.5- in a 5/ ear 4ero/coupon bond and a position of *-05..9 in a 2/ ear 4ero/coupon bond. )he equivalent 5/ ear and 2/ ear cash flows are .8.5- %.0-5 = -..98 and -05..9 %.02 2 = 922.28 .
Problem 20.1". 3ome time ago a company entered into a for"ard contract to !uy 8( million for '(.5 million. .he contract no" has six months to maturity. .he daily volatility of a six,month /ero,coupon sterling !ond 5"hen its price is translated to dollars6 is 0.04\$ and the daily volatility of a six,month /ero,coupon dollar !ond is 0.05\$. .he correlation !et"een returns from the t"o !onds is 0.8. .he current exchange rate is (.5+. &alculate the standard deviation of the change in the dollar value of the for"ard contract in one day. What is the (0,day 99\$ 0a1Assume that the six,month interest rate in !oth sterling and dollars is 5\$ per annum "ith continuous compounding. )he contract is a long position in a sterling bond combined with a short position in a dollar bond. )he value of the sterling bond is %.5,e 0.050.5 or *%..92 million. )he value of the dollar bond is %.5e 0.050.5 or *%..-, million. )he variance of the change in the value of the contract in one da is %..92 2 0.000-2 + %..-,2 0.00052 2 0.8 %..92 0.000- %..-, 0.0005

= 0.000000288 )he standard deviation is therefore *0.0005,2 million. )he %0/da 991 VaR is 0.0005,2 %0 2.,, = '0.00,9- million.
Problem 20.1#. .he most recent estimate of the daily volatility of the 9.3. dollar:sterling exchange rate is 0.4\$) and the exchange rate at ; p.m. yesterday "as (.5000. .he parameter in the EWMA model is 0.9. 3uppose that the exchange rate at ; p.m. today proves to !e (.;950. <o" "ould the estimate of the daily volatility !e updated)he dail return is 0.005 / %.5000 = 0.00,,,, . )he current dail variance estimate is 0.00- 2 = 0.0000,- . )he new dail variance estimate is 0.9 0.0000,- + 0.% 0.00,,,,2 = 0.0000,,5%% )he new volatilit is the square root of this. 9t is 0.00529 or 0.5291. Problem 20.18. 3uppose that the daily volatilities of asset A and asset * calculated at close of trading yesterday are (.4\$ and =.5\$) respectively. .he prices of the assets at close of trading yesterday "ere '=0 and ';0) and the estimate of the coefficient of correlation !et"een the returns on the t"o assets made at close of trading yesterday "as 0.=5. .he parameter used in the EWMA model is 0.95. 5a6 &alculate the current estimate of the covariance !et"een the assets. 5!6 >n the assumption that the prices of the assets at close of trading today are '=0.5 and ';0.5) update the correlation estimate. a& )he volatilities and correlation impl that the current estimate of the covariance is 0.25 0.0%- 0.025 = 0.000% . b& 9f the prices of the assets at close of trading toda are *20.5 and *.0.5' the returns are 0.5 / 20 = 0.025 and 0.5 / .0 = 0.0%25 . )he new covariance estimate is 0.95 0.000% + 0.05 0.025 0.0%25 = 0.000%%0)he new variance estimate for asset 7 is 0.95 0.0%- 2 + 0.05 0.0252 = 0.00022..5 so that the new volatilit is 0.0%--. )he new variance estimate for asset < is 0.95 0.0252 + 0.05 0.0%252 = 0.000-0%5-2 so that the new volatilit is 0.02.5. )he new correlation estimate is 0.000%%0= 0.222 0.0%-- 0.02.5 Problem 20.19. 3uppose that the daily volatility of the ?.,3E (00 stoc index 5measured in pounds sterling6 is (.8\$ and the daily volatility of the dollar@sterling exchange rate is 0.9\$. 3uppose further that the correlation !et"een the ?.,3E (00 and the dollar@sterling exchange rate is 0.;. What is the volatility of the ?.,3E (00 "hen it is translated to 9.3. dollars- Assume that the dollar@sterling exchange rate is expressed as the num!er of 9.3. dollars per pound sterling. 5<intA When B = #C ) the percentage daily change in B is approximately e7ual to the percentage daily change in # plus the percentage daily change in C .6

)he 0)/=( e#pressed in dollars is #C where # is the 0)/=( e#pressed in sterling and C is the e#change rate \$value of one pound in dollars&. >efine xi as the proportional change in # on da i and yi as the proportional change in C on da i . )he proportional change in #C is appro#imatel xi + yi . )he standard deviation of xi is 0.0%8 and the standard deviation of yi is 0.009. )he correlation between the two is 0... )he variance of xi + yi is therefore
0.0%82 + 0.0092 + 2 0.0%8 0.009 0.. = 0.0005,.so that the volatilit of xi + yi is 0.02,% or 2.,%1. )his is the volatilit of the 0)/=( e#pressed in dollars. ?ote that it is greater than the volatilit of the 0)/=( e#pressed in sterling. )his is the impact of the positive correlation. 3hen the 0)/=( increases the value of sterling measured in dollars also tends to increase. )his creates an even bigger increase in the value of 0)/=( measured in dollars. =imilarl for a decrease in the 0)/=(.

Problem 20.20. 3uppose that in Dro!lem =0.(9 the correlation !et"een the 3ED 500 Index 5measured in dollars6 and the ?.,3E (00 Index 5measured in sterling6 is 0.2) the correlation !et"een the 3ED 500 index 5measured in dollars6 and the dollar,sterling exchange rate is 0.+) and the daily volatility of the 3ED 500 Index is (.4\$. What is the correlation !et"een the 3ED 500 Index 5measured in dollars6 and the ?.,3E (00 Index "hen it is translated to dollars- 5<intA ?or three varia!les # ) C ) and B ) the covariance !et"een # + C and B e7uals the covariance !et"een # and B plus the covariance !et"een C and B .6 8ontinuing with the notation in @roblem 20.%9' define /i as the proportional change in the value of the =A@ 500 on da i . )he covariance between xi and /i is 0.2 0.0%8 0.0%- = 0.00020%- . )he covariance between yi and /i is 0., 0.009 0.0%- = 0.0000.,2 . )he covariance between xi + yi and /i equals the covariance between xi and /i plus the covariance between yi and /i . 9t is 0.00020%- + 0.0000.,2 = 0.0002..8 )he correlation between xi + yi and /i is 0.0002..8 = 0.--2 0.0%- 0.02,% Problem 20.21. .he one,day 99\$ 0a1 is calculated for the four,index example in 3ection =0.= as '=;2)52(. Foo at the underlying spreadsheets on the authorGs "e! site and calculate the a6 the 95\$ one,day 0a1 and !6 the 92\$ one,day 0a1. )he 951 one/da VaR is the 25th worst loss. )his is *%-8'-%2. )he 921 one/da VaR is the %5th worst loss. )his is *%88'258. Problem 20.22. 9se the spreadsheets on the authorGs "e! site to calculate the one,day 99\$ 0a1) using the !asic methodology in 3ection =0.= if the four,index portfolio considered in 3ection =0.= is e7ually divided !et"een the four indices.

9n the !=cenarios" worksheet the portfolio investments are changed to 2500 in cells :2B62. )he losses are then sorted from the largest to the smallest. )he fifth worst loss is *258',55. )his is the one/da 991 VaR. Problem 20.23. At the end of 3ection =0.4) the 0a1 for the four,index example "as calculated using the model,!uilding approach. <o" does the 0a1 calculated change if the investment is '=.5 million in each index- &arry out calculations "hen a6 volatilities and correlations are estimated using the e7ually "eighted model and !6 "hen they are estimated using the EWMA model "ith = 0.9. . 9se the spreadsheets on the authorGs "e! site. )he alphas \$row 2% for equal weights and row 2 for (3C7& should be changed to 2'500. )his changes the one/da 991 VaR to *2,8'022 when volatilities and correlations are estimated using the equall weighted model and to *5%0'.59 when (3C7 with = 0.9. is used. Problem 20.2 . What is the effect of changing from 0.9; to 0.92 in the EWMA calculations in the four, index example at the end of 3ection =0.4- 9se the spreadsheets on the authorGs "e! site. )he parameter is in cell ?, of the (3C7 worksheet. 8hanging it to 0.92 changes the one/ da 991 VaR from *.88'2%2 to *.0.'--%. )his is because less weight is given to recent observations.

\$urt%er Problems
Problem 20.2!. &onsider a position consisting of a '+00)000 investment in gold and a '500)000 investment in silver. 3uppose that the daily volatilities of these t"o assets are (.8\$ and (.=\$) respectively) and that the coefficient of correlation !et"een their returns is 0.4. What is the (0,day 92.5\$ value at ris for the portfolio- *y ho" much does diversification reduce the 0a1)he variance of the portfolio \$in thousands of dollars& is 0.0%82 ,002 + 0.0%2 2 500 2 + 2 ,00 500 0.- 0.0%8 0.0%2 = %0..0. )he standard deviation is %0..0. = %0.2 . =ince % \$%.9-& = 0.025 ' the %/da 92.51 VaR is %0.2 %.9- = %9.99 and the %0/da 92.51 VaR is %0 %9.99 = -,.22 . )he %0/da 92.51 VaR is therefore *-,'220. )he %0/da 92.51 value at risk for the gold investment is 5, .00 %0 %.9- = ,,, .20 . )he %0/da 92.51 value at risk for the silver investment is
-, 000 %0 %.9- = ,2,%88 . )he diversification benefit is ,,, .20 + ,2,%88 -,, 220 = '2, .,8

Problem 20.2". &onsider a portfolio of options on a single asset. 3uppose that the delta of the portfolio is (=) the value of the asset is '(0) and the daily volatility of the asset is =\$. Estimate the (,day 95\$ 0a1 for the portfolio. 3uppose that the gamma of the portfolio is 2.- . Herive a 7uadratic relationship !et"een the change in the portfolio value and the percentage change

in the underlying asset price in one day. 7n appro#imate relationship between the dail change in the value of the portfolio' D and the return on the asset x is D = %0 %2x = %20x )he standard deviation of x is 0.02. 9t follows that the standard deviation of D is 2... )he %/da 951 VaR is 2..D%.-5 E *,.9-. 0rom equation \$20.5& the quadratic relationship between D and x is % D = %0 %2x %0 2 2.-\$ x& 2 2 or D = %20x %,0\$x& 2 Problem 20.2#. A !an has "ritten a call option on one stoc and a put option on another stoc . ?or the first option the stoc price is 50) the stri e price is 5() the volatility is =8\$ per annum) and the time to maturity is nine months. ?or the second option the stoc price is =0) the stri e price is (9) the volatility is =5\$ per annum) and the time to maturity is one year. %either stoc pays a dividend) the ris ,free rate is 4\$ per annum) and the correlation !et"een stoc price returns is 0.;. &alculate a (0,day 99\$ 0a1 using HerivaIem and the linear model. C answer follows the usual practice of assuming that the %0/da 991 value at risk is %0 times the %/da 991 value at risk. =ome students ma tr to calculate a %0/da VaR directl ' which is fine. 0rom >erivaFem' the values of the two option positions are G5..%, and G %.0%.. )he deltas are G0.589 and 0.28.' respectivel . 7n appro#imate linear model relating the change in the portfolio value to proportional change' x% ' in the first stock price and the proportional change' x2 ' in the second stock price is D = 0.589 50x% + 0.28. 20x2 or D = 29..5x% + 5.-8x2 )he dail volatilit of the two stocks are 0.28 / 252 = 0.0%2- and 0.25 / 252 = 0.0%52 ' respectivel . )he one/da variance of D is 29..52 0.0%2- 2 + 5.-82 0.0%52 2 2 29..5 0.0%2- 5.-8 0.0%52 0.. = 0.2,9)he one da standard deviation is' therefore' 0..895 and the %0/da 991 VaR is 2.,, %0 0..895 = ,.-% . Problem 20.28. 3uppose that the price of gold at close of trading yesterday "as '400) and its volatility "as estimated as (.+\$ per day. .he price at the close of trading today is '594. 9pdate the volatility estimate using the EWMA model "ith = 0.9. . )he return on gold is . / ,-00 = 0.00--2 . ;sing the (3C7 model the variance is updated to 0.9. 0.0%,2 + 0.0- 0.00--2 2 = 0.000%-%5. so that the new dail volatilit is 0.000%-%5. = 0.0%22% or %.22%1 per da . Problem 20.29.

3uppose that in Dro!lem =0.=8 the price of silver at the close of trading yesterday "as '(4) its volatility "as estimated as (.5\$ per day) and its correlation "ith gold "as estimated as 0.8. .he price of silver at the close of trading today is unchanged at '(4. 9pdate the volatility of silver and the correlation !et"een silver and gold using the EWMA model "ith = 0.9. . )he return on silver is 4ero. ;sing the (3C7 model the variance is updated to 0.9. 0.0%52 + 0.0- 0 = 0.0002%%5 so that the new dail volatilit is 0.0002%%5 = 0.0%.5. or %..5.1 per da . )he initial covariance is 0.8 0.0%, 0.0%5 = 0.000%5- ;sing (3C7 the covariance is updated to 0.9. 0.000%5- + 0.0- 0 = 0.000%.--. so that the new correlation is 0.000%.--. / \$0.0%.5. 0.0%22%& = 0.29,, Problem 20.30. &E'cel (ile) An Excel spreadsheet containing daily data on a num!er of different exchange rates and stoc indices can !e do"nloaded from the authorGs We! siteA httpA@@""".rotman.utoronto.ca@ : hull@data &hoose one exchange rate and one stoc index. Estimate the value of in the EWMA model that minimi/es the value of \$vi i &2
i

"here vi is the variance forecast made at the end of day i % and i is the variance calculated from data !et"een day i and i + 25 . 9se ExcelGs 3olver tool. 3et the variance forecast at the end of the first day e7ual to the s7uare of the return on that day to start the EWMA calculations. 9n the spreadsheet the initial volatilit is assumed to be the average volatilit for the whole period \$calculated in the usual wa & and the first 25 observations on \$vi/&2 are ignored so that the results are not undul influenced b the choice of starting values. )he best values of for (;R' 87>' F<@ and H@I were found to be 0.9.,' 0.900' 0.9,2' and 0.928' respectivel . )he best values of for =A@500' ?7=>7J' 0)=(%00' and ?ikkei225 were found to be 0.8-.' 0.89-' 0.889' and 0.852' respectivel . Problem 20.31. A common complaint of ris managers is that the model !uilding approach 5either linear or 7uadratic6 does not "or "ell "hen delta is close to /ero. .est "hat happens "hen delta is close to /ero in using 3ample Application E in the HerivaIem Application *uilder soft"are. 5Cou can do this !y experimenting "ith different option positions and adJusting the position in the underlying to give a delta of /ero.6 Explain the results you get. 3e can create a portfolio with 4ero delta in =ample 7pplication ( b changing the position in the stock from %'000 to 5%,.58. \$)his reduces delta b %, 000 5%,.58 = .8-..2 .& 9n this case the true VaR is .8.8-K the VaR given b the linear model is 0.00K and the VaR given b the quadratic model is /,5.2%. 6ther 4ero/delta e#amples can be created b changing the option portfolio and then 4eroing out delta b ad5usting the position in the underl ing asset. )he results are similar. )he software shows that neither the linear model nor the quadratic model gives good answers when delta is 4ero. )he linear model alwa s gives a VaR of 4ero because the model assumes

that the portfolio has no risk. \$0or e#ample' in the case of one underl ing asset D = 3 .& 3hen there are no cross gammas the quadratic model assumes that D is alwa s positive. \$0or e#ample' in the case of one underl ing asset D = 0.5 \$3 & 2 .& )his gives a negative VaR. 9n practice man portfolios do have deltas close to 4ero because of the hedging activities described in 8hapter %2. )his has led man financial institutions to prefer historical simulation to the model building approach. Problem 20.32 &E'cel (ile) 3uppose that the portfolio considered in 3ection =0.= has 5in '000s6 +)000 in HKIA) +)000 in ?.3E) ()000 in &A&;0) and +)000 in %i ei ==5. 9se the spreadsheet on the authorGs "e! site to calculate "hat difference this ma es to the one,day 99\$ 0a1 that is calculated in 3ection =0.=. 0irst the investments worksheet is changed to reflect the new portfolio allocation. \$see row 2 of the =cenarios worksheet for historical simulation&. )he losses are then sorted from the greatest to the least. )he one/da 991 VaR is the fifth worst loss or *2,0'892. Problem 20.33 &E'cel (ile) .he calculations for the four,index example at the end of 3ection =0.4 assume that the investments in the HKIA) ?.3E (00) &A&;0) and %i ei ==5 are '; million) '+ million) L'( million) and '= million) respectively. <o" does the 0a1 calculated change if the investment are '+ million) '+ million) '( million) and '+ million) respectively- &arry out calculations "hen a6 volatilities and correlations are estimated using the e7ually "eighted model and !6 "hen they are estimated using the EWMA model. What is the effect of changing from 0.9; to 0.90 in the EWMA calculations- 9se the spreadsheets on the authorMs "e! site. \$a& )he portfolio investment amounts have to be changed in row 2% of the (qual 3eights worksheet for the model building approach. )he worksheet shows that the new one/ da 991 VaR is *229'-8,. )his is slightl higher than the one/da VaR for the original portfolio. \$b& )he portfolio investment amounts have to be changed in row 2 of the (3C7 worksheet. )he worksheet shows that one/da 991 VaR is *.28'895. )his is slightl lower than the one/da VaR for the original portfolio. 8hanging to 0.90 \$see cell ?,& changes VaR to *5,2'828. )his is higher because recent returns are given more weight.