Introduction

Description of the approach

An application to portfolio optimization

Remarks

Optimization of conditional Value-at-Risk

Petr Zahradnk
Matematicko- fyzik
aln fakulta
Univerzity Karlovy v Praze

jna 2008
20. R

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

1 Introduction

Motivation
VaR is simply a WRONG approach
2 Description of the approach

The general concept

Advantages of our formula
3 An application to portfolio optimization

General example
VaR, cVaR and 2
4 Remarks

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

Motivation

What are we here for?

We disclose a new approach to a technique for optimizing a

portfolio, which calculates VaR and CVaR simultaneously.
Our approach is suitable for use for anybody investing into
risky assets.
Combined with analytical or scenario based methods choosing
the portfolios with constraints such as a minimal gain, the
calculations often come down to basic linear programming.

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

Motivation

VaR
QUESTION: How can we measure risk?

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

Motivation

VaR
QUESTION: How can we measure risk?
The (unfortunately) most popular measure of risk is the
Value-at-Risk.

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

Motivation

VaR
QUESTION: How can we measure risk?
The (unfortunately) most popular measure of risk is the
Value-at-Risk.
A more modern (and correct) approach are coherent
measures.

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

Motivation

VaR
QUESTION: How can we measure risk?
The (unfortunately) most popular measure of risk is the
Value-at-Risk.
A more modern (and correct) approach are coherent
measures.
Usual definition of VaR:

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

Motivation

VaR
QUESTION: How can we measure risk?
The (unfortunately) most popular measure of risk is the
Value-at-Risk.
A more modern (and correct) approach are coherent
measures.
Usual definition of VaR:
Given a confidence level and a time interval [t, t + ] the
Var of a portfolio with a value process Vt is given by:
VaR = inf{v R : P(Vt Vt+ > v |Ft ) < }

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR is simply a WRONG approach

Example: VAR is a bad concept

QUESTION: Why on earth should any measure of

risk have a same value for these two cases?
Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR is simply a WRONG approach

Example: sub-additivity assumption broken

Let us have an almost trivial portfolio consisting of two risky
assets (Xt , Yt ) and a portfolio value proces Vt = Xt + Yt .
Conditional on Ft let (Xt , Yt ) be :
(0, 0) with prob. 1 2 and (c, 0) resp. (0, c) with prob. .
What is VaR (X ) resp. VaR (Y )?

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR is simply a WRONG approach

Example: sub-additivity assumption broken

Let us have an almost trivial portfolio consisting of two risky
assets (Xt , Yt ) and a portfolio value proces Vt = Xt + Yt .
Conditional on Ft let (Xt , Yt ) be :
(0, 0) with prob. 1 2 and (c, 0) resp. (0, c) with prob. .
What is VaR (X ) resp. VaR (Y )?
Yes, it is ZERO
What is VaR (V ) ?

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR is simply a WRONG approach

Example: sub-additivity assumption broken

Let us have an almost trivial portfolio consisting of two risky
assets (Xt , Yt ) and a portfolio value proces Vt = Xt + Yt .
Conditional on Ft let (Xt , Yt ) be :
(0, 0) with prob. 1 2 and (c, 0) resp. (0, c) with prob. .
What is VaR (X ) resp. VaR (Y )?
Yes, it is ZERO
What is VaR (V ) ?
Yes, it is c. Diversified portfolio led to a bigger risk.

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR is simply a WRONG approach

Example: sub-additivity assumption broken

Let us have an almost trivial portfolio consisting of two risky
assets (Xt , Yt ) and a portfolio value proces Vt = Xt + Yt .
Conditional on Ft let (Xt , Yt ) be :
(0, 0) with prob. 1 2 and (c, 0) resp. (0, c) with prob. .
What is VaR (X ) resp. VaR (Y )?
Yes, it is ZERO
What is VaR (V ) ?
Yes, it is c. Diversified portfolio led to a bigger risk.
I hope we agreed on the fact, that VaR is a deeply wrong
way to measure risk. However, a lot of people still use it.
Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR is simply a WRONG approach

Lets begin with something more reasonable then!

The coherent measures are a reasonable concept- we assume:

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR is simply a WRONG approach

Lets begin with something more reasonable then!

The coherent measures are a reasonable concept- we assume:
monotonicity,
sub-additivity,
positive homogenity
translation invariance

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

The general concept

Definitions:
Suppose a threshold , a loss function f (x, y ), a random
vector y having a density p(y ):

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

The general concept

Definitions:
Suppose a threshold , a loss function f (x, y ), a random
vector y having a density p(y ):
The probability of f (x, y ) not exceeding a threshold given a
decision vector x is given by:
Z
(x, ) =
p(y )dy
f (x,y )

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

The general concept

Definitions:
Suppose a threshold , a loss function f (x, y ), a random
vector y having a density p(y ):
The probability of f (x, y ) not exceeding a threshold given a
decision vector x is given by:
Z
(x, ) =
p(y )dy
f (x,y )

The definition of VaR to be used from now on:

(x) = min{ R : (x, ) }

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

The general concept

Definitions:
Suppose a threshold , a loss function f (x, y ), a random
vector y having a density p(y ):
The probability of f (x, y ) not exceeding a threshold given a
decision vector x is given by:
Z
(x, ) =
p(y )dy
f (x,y )

The definition of VaR to be used from now on:

(x) = min{ R : (x, ) }
The definition of cVaR:
(x) = (1 )

Z
f (x, y )p(y )dy
f (x,y ) (x)

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

The general concept

Remarks
VaR still means the same, we have only rewritten it and the
threshold was named .
cVaR is a conditional expectation!
The definitions ensure that VaR is never more than cVaR!
Therefore, portfolios with low cVaR must have low VaR as
well.
cVaR is still not generally a coherent measure. It can be easily
improved to meet the criteria though, for example
if the
R
cumulative distribution function (x, ) = f (x,y ) p(y )dy is
everywhere continuous wrt .
The density p(y ) need not exist for the concept to work
either. The generalization is left for further study.
Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

The general concept

The key of the concept

We want to characterize cVaR and VaR in terms of a function F
on X x R defined as follows:
Z
1
F (x, ) = + (1 )
[f (x, y ) ]+ p(y )dy .
y R m

The crucial features of the function F are:

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

The general concept

The key of the concept

We want to characterize cVaR and VaR in terms of a function F
on X x R defined as follows:
Z
1
F (x, ) = + (1 )
[f (x, y ) ]+ p(y )dy .
y R m

The crucial features of the function F are:

convexity and continuous differentiability wrt .
(x) argminR F (x, )
(x) = F (x, (x)) = minR F (x, )
The interval argminR F (x, ) perhaps can reduce to a single
point. Also, the minimization of F means the same as minimizing
(1 )F which will probably be more numerically feasible.
Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

The general concept

The power of the formula at the previous slide is apparent:

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

The general concept

The power of the formula at the previous slide is apparent:

Continuously differentiable functions are easy to minimize.
cVaR can obviously be computed without first calculating the
VaR on which its definition depends.
VaR may be obtain as a by-product (for those, who still want
to know it...)
R
F (x, ) = + (1 )1 y R m [f (x, y ) ]+ p(y )dy can be
approximated, for example by sampling from the distribution
of y according to its density p(y ). The corresponding
approximation, from a sample y1 , . . . , yq would be:
X
1
F0 (x, ) = + (1 )1
[f (x, y ) ]+ .
q
k1,...,q

This expression is piecewise linear and convex wrt . LP

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

Advantages of our formula

Minimizing cVaR- the formula

minxX (x) = min(x,)X R F (x, )

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

Advantages of our formula

Minimizing cVaR- the formula

minxX (x) = min(x,)X R F (x, )
The pair (x , ) achieves the second minimum x
achieves the first minimum. Therefore, the joint minimization
of F leads to a pair (x , ), such that x minimizes the
cVaR and gives the corresponding VaR.
f (x, y ) and constraints for X convex leads to minimizing
convex functions. CP
The approximation of the integral to be minimized can again
work.
The minimization of F falls into category of stochastic
programming.
Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

General example

P
Suppose xj 0 with
xj = 1. Let yj be the return on the j-th
instrument. The density of the joint distribution of y denote p(y ).
The loss is therefore given by
f (x, y ) = x T y .
Here, our VaR and cVaR will be defined in terms of the percentage
returns. We consider the case, where we have a one-to-one
correspondance between percentage returns and a monetary value.
(Which is of course not the case of portfolios with zero net
investment)

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

General example

The performance function to focus on:

Z
1
F (x, ) = + (1 )
[x T y ]+ p(y )dy
y R n

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

General example

The performance function to focus on:

Z
1
F (x, ) = + (1 )
[x T y ]+ p(y )dy
y R n

fact: in this setting, F (x, ) is a convex function of both x

and .
sometimes fact: it is also often differentiable in these variables
(details not to be dealt with)
Hence we can often use the formulas formulated earlier!

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

General example

A closer look
For a more detailed look, let (x) and (x) denote the mean and
the variance of the loss associated with the portfolio respectively;
in terms of mean m and variance V of y , introducing a constraint
on minimal expected gain, we have:

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

General example

A closer look
For a more detailed look, let (x) and (x) denote the mean and
the variance of the loss associated with the portfolio respectively;
in terms of mean m and variance V of y , introducing a constraint
on minimal expected gain, we have:
(x) = x T m, 2 (x) = x T Vx
P
X = {x : xj = 1, (x) R}.
A sample set y1 , . . . , yq yields:
X
1
F0 (x, ) = + (1 )1
[x T yk ]+ .
q
k1,...,q

The problem broke into a problem of linear programming.

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR, cVaR and 2

Now we want to cope with the fact, that we directed the discussion
towards minimizing cVaR and calculated VaR in the meantime.
Now we would like to know, as we introduced the variance of our
loss, what is the connection of following three problems:

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR, cVaR and 2

Now we want to cope with the fact, that we directed the discussion
towards minimizing cVaR and calculated VaR in the meantime.
Now we would like to know, as we introduced the variance of our
loss, what is the connection of following three problems:
minimize (x) over x X
minimize (x) over x X
minimize 2 (x) over x X , a popular Markowitz (1952)
problem.

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR, cVaR and 2

Now we want to cope with the fact, that we directed the discussion
towards minimizing cVaR and calculated VaR in the meantime.
Now we would like to know, as we introduced the variance of our
loss, what is the connection of following three problems:
minimize (x) over x X
minimize (x) over x X
minimize 2 (x) over x X , a popular Markowitz (1952)
problem.
These problems can yield, in at least one important case, the
same optimal portfolio!!!

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR, cVaR and 2

The most important proposition

Suppose that the loss associated with each x is

normally distributed, as holds when y is normally
distributed. If 0.5 and the constraint (x) R is
active at solutions to any two of the problems, then
the solutions to those two problems is the same; a
common portfolio x is optimal by both criteria.

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR, cVaR and 2

The most important proposition- continued

The proof can be done using the capabilities of mathematical

software which expresses the VaR and cVaR in terms of the
mean and variance of the Normal distribution. The mean is
then replaced by R as the constraint is assumed to be active.
The proposition gives us an opportunity to test the methods
proposed earlier by computing the optimal portfolio using
quadratic programming solutions for the Markowitz problem.

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

VaR, cVaR and 2

Of course, the real life shows that the assets to deal with are often
very far from being normally distributed. The cVaR optimizing
method works very well even in these cases, as it is independent of
the normality assumption, and hence can be used broadly. As
[Rockafellar and Uryasev] show on a hedging example, it works
much better than other commonly used parametric and simulation
VaR techniques. For example, it copes much better with varying
more then one position within a specified range etc., also using
so-called non-smooth optimization techniques. Numerical
computations have been conducted for very large problems and
proved valid results.

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

What did we manage?

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

What did we manage?

We showed how to minimize cVaR and compute VaR

simultaneously.
We stressed why VaR shouldnt be used.
We had fun and/or slept well.

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

: The End.
Voila
Any questions?
Thank you for attention.
Bibliography:
Optimization of conditional valute-at-risk by R.T. Rockafellar
and S. Uryasev, available online for free.
A paper by Karel Janecek at
http://www.rsj.cz/index.php?id document=200576104

Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze

Introduction

Description of the approach

An application to portfolio optimization

Remarks

: The End.
Voila
Any questions?
Thank you for attention.
Bibliography:
Optimization of conditional valute-at-risk by R.T. Rockafellar
and S. Uryasev, available online for free.
A paper by Karel Janecek at
http://www.rsj.cz/index.php?id document=200576104
webpage: petr.anoel.eu
mailto: petr@anoel.eu
Petr Zahradnk
Optimization of cVaR

Matematicko- fyzik
aln fakulta Univerzity Karlovy v Praze