VAR

May 30, 2018 1

 Evolution of Analytical Risk
Management Tools
Year Name of Risk Management Tool
1938 Bond Duration
1952 Markovitz Mean Variance Framework
1963 Sharpe Single Factor Beta Model
1966 Multiple Factor Model
1973 Black-Scholes-Merton Option Pricing Model & Greeks
1983 Risk Adjusted Returns, RAROC
1986 Limits of Exposure by Duration Buckets
1988 Limits on Greeks
1992 Stress Testing
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 Evolution of Analytical Risk
Management Tools
Year Name of Risk Management Tool
1993 Value at Risk
1994 RiskMetrics (JP Morgan)
1997 CreditMatrics (CreditSuisse)
1998 Integration of Credit & Market Risks
2000 Enterprise Risk Management
VaR – VaR summarizes the “Worst Loss” over a target horizon
that will not be exceeded with a given level of confidence
Till Guldimann, the then Head of JPM Global Research is viewed
as the Creator of VaR
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 Value At Risk (VaR)
A portfolio manager wants to add an asset in his
portfolio. If the asset has daily σ of returns
1.40% and the asset has a current value of $5.30
mio., calculate the VaR (5%) on both percentage
and Dollar basis –
 VaR (%) = Zx% multiplied by σ
 Discuss - appropriate critical z values for
significance level 10%, 5%, and 1% (1.28, 1.65,
2.33)
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 VaR Calculation
 So VaR (5%) = 1.65 x 0.014 = 0.0231
= 2.31%
 VaR (5%) in $ terms = 2.31% x $ 5.30 mio i.e.
$122,430
 Interpretation of above VaR – There is 5% probability
that on a given day the loss in value of the asset will
equal to or exceed 2.31% or $ 122,430 Or
 There is 95% probability that on a given day the loss in
the value of the asset will be less than 2.31% or $122,430

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 VaR and Expected return
 For $100 mio portfolio, the expected ONE
week return and σ are 0.00188 and 0.0125
respectively. Calculate the 1 week VaR at 5%
significance.
 VaR (5%) = [E( R) - Z σ ] x Portfolio Value
= [0.00188 – 1.65 (0.0125)] x 100 mio
= $ 1,874,500
The manager can be 95% confident that the
maximum 1 week loss will not exceed $1,874,500
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 VaR and time conversion

 VaR can be converted from 1 day basis to a

longer basis by multiplying the daily VaR by
square root of no. of days;
 So VaR (X%)t-days = VaR (X%)1-day x √t
 Assume daily VaR (10%) on dollar basis is
12,500, calculate weekly, monthly, semi-annual
and annual VaR for this. Assume 250 days per
year and 50 weeks per year

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 VaR & Time Conversion
 VaR (10%)weekly OR 5days
VaR(10%)1day x √5 = 12500 x √5 = $27,951
 VaR (10%)monthly OR 20days
VaR(10%)1day x √20 = 12500 x √20 = $55,902
 VaR (10%)HY OR 125days
VaR(10%)1day x √125 = 12500 x √125 =$139,754
 VaR (10%)Yearly OR 250days
VaR(10%)1day x √250 = 12500 x √250 =$197,642

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 VaR Methods

 VaR Methods

VaR Methods

Analytical Method
Or
Monte Carlo Simulation
Delta-Normal Method Historical Simulation Method
Method
Or
Variance-Covariance Method

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 Analytical Method
 The expected 1 day return for $100 mio portfolio is 0.00085 and
the historical σ of daily returns is 0.0011. Calculate VaR at 5%
significance
 VaR = |Rp –(z)(σ)|Vp
=|0.00085-(1.65)(0.0011)|($100 mio)
= $96,500
The interpretation of this VaR is that there is a 5% chance that the
minimum 1 day loss is 0.0965%, or $96,500 or more (i.e. there is
5% probability that the 1 day loss will exceed $96,500).
Alternatively, we could say that we are 95% confident that the 1
day loss will not exceed $96,500
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 Historical Simulation Method
 Suppose we have accumulated 100 daily returns for our
portfolio of $100 mio. After ranking the returns from highest
to lowest, we identify the lowest six returns as under –
-0.0011, -0.0019, -0.0025, -0.0034, -0.0096, -0.0101
 Calculate daily VaR at 5% significance level using historical
simulation method
 VaR = |Rp|Vp
=|0.0019)|($100 mio)
= $190,000
The lowest 5 returns represent the 5% lower tail of the
“distribution of 100 historical returns. The 5th lowest return
(i.e. -0.0019) is the 5% daily VaR. We would say that there is a
5% chance of daily loss exceeding 0.19%, or $190,000
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 Monte Carlo Simulation Method
 A Monte Carlo output specifies the expected 1 week portfolio
return and σ are 0.00188 and 0.0125 respectively (see Monte
Carlo random no. generator )
 Calculate the 1 week VaR at 1% significance level using this
monte carlo simulation method
 VaR = |Rp- (z)(σ )|Vp
=|0.00188-(2.33)(0.0125)|($100 mio)
= $2,724,500
The manager can be 99% confident that the maximum 1 week loss
will not exceed $2,724,500. Alternatively, the manager could say
that there is 1% probability that the loss will be $2,724,500 or
greater (i.e. the portfolio will lose at least $2,724,500)
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 VaR – Decomposition
 Decomposition
Decomposition
of VaR

Diversified Component Incremental

Marginal VaR VaR
VaR VaR

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 Diversified VaR of Portfolio

 Diversified VaR =
 √VaRa2 +VaRb2 + 2VaRa x VaRb x pab

 Asset E( R) Volatility Weight

Stock 24% 18% 0.50
Bond 15% 6% 0.50
Calculate 99% VaR of portfolio if p = 0.1 and value
of portfolio is 100 mio
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 Diversified VaR of Portfolio
 VaR = Z x σ x Portfolio Value
VaRstock = 2.33 x 0.18 x 50 mio = 20.97 mio
VaRbond = 2.33 x 0.06 x 50 mio = 6.99 mio
 Diversified VaR =
 √VaRs2 +VaRb2 + 2VaRs x VaRb x psb
 √20.972 + 6.992+ 2x20.97x6.99x0.1
= 22.76 mio
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Diversified VaR of Portfolio
 VaR for uncorrelated position (rho=0)
 √VaRs2 +VaRb2 + 2VaRs x VaRb x psb = √VaRs2 +VaRb2
 VaR for perfectly correlated position
(rho=1)
 √VaRs2 +VaRb2 + 2VaRs x VaRb x psb = VaRs+VaRb
 Undiversified VaR (i.e. no benefit from
diversification)

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Component, Marginal and Incremental VaR

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Marginal VaR
 Per unit change in a portfolio VaR that occurs from an
additional investment in that position
 Marginal VaR = Port. Diversified VaR x Beta/Portfolio value or
 Marginal VaR =Zc x Covariance(i, Portfolio)/Portfolio Std Dev.
 A portfolio X has a VaR of $4000. the portfolio is made up of
four assets, A,B,C and D. these are equally weighted within the
portfolio and are each valued at $1,000,000. Asset A has a beta
of 1.2 calculate the marginal VaR of asset A.
 Marginal VaR of A = Port. Diversified VaR x Beta/Portfolio
value
= (4000/4,000,000) (1.2) = $ 0.0012
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Incremental VaR
 Is the change in VaR from the addition of a new position
in a portfolio. By definition it should be larger than
marginal var and hence portfolio VaR changes in a non-
linear fashion.
 Incremental VaR =
Var before the addition of new position - VaR after the
addition of new position
 Incremental VaR is approximately equal to
= (Marginal VaRi) X Change in position (either addition or
subtraction)
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Component VaR
 A partition of the portfolio VaR that indicates how much
the portfolio VaR would change approximately if the
given component was deleted.
Or
component var is the amount of risk a particular fund
contributes to a portfolio. Component VaRs should sum
to portfolio VaR.
 Component VaR = Diversified VaR x Beta of asset x
Weight in portfolio or = Marginal VaR x Respective
weight in portfolio x portfolio value
 = VaRp x Bi x Wi or = MVaRi x Wi x Portfolio Value
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 Component & Marginal VaR
 Example
Asset Value(000) Volatility Beta
A 400 3.60% 0.50
B 600 8.63% 1.20
Port 1000 5.92% 1.00
Calculate 95% Component VaR of A and Marginal VaR of
B

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 Component & Marginal VaR
 First D VaR = Z σ Value
= 1.645 x 0.0592 x 1,000,000
= 97,384
 Now Component VaR of A = Diversified VaR x Beta of asset
x Weight in portfolio
= 97384 x 0.50 X 400/1000 = 19476
 Marginal VaR of B = Diversified VaR x Beta/Portfolio value
= 97 384 x 1.2/1,000,000
= 0.1169

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 Portfolio Standard Deviation – special case

 If correlation across each pair of position is

same, and the value of each position is same
then, portfolio standard deviation can be
calculated as under –
Std Dev [(1/N + {1-(1/N)}p]1/2
 Then we can calculate the VaR of the
portfolio

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HomeWork
 Read Chapter 7; Jorion, VAR, 3e and solve
problems given at the end of the chapter.

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 THANK YOU

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