BWRR3063 FINANCIAL RISK MANAGEMENT

Definition and importance of Value at Risk

Value at risk is defined as the value that can be expected to be lost during severe market
fluctuations or it measures potential loss in value of a risky assets or portfolio over a defined
period for a given confidence interval. In this Value at Risk method, the manager of financial
instruments will make statement as We are X percent certain that we will not lose more than
V dollars in the next N days,where the V is VaR of the portfolio, N is the time horizon and X
is the confidence level. The importances of Value at Risk method are, it ensure balance sheet
solveny because by measuring the risk exposure it capture the potential loss and compared
against their valuable capital and cash reserve. Besides that, VaR also help to prevent an
insolvency crisis, where a loss will be created at low probability catastrophic that wipe down
a firms entire capital base.
Methods in calculating Value at Risk
Historical stimulations.
In this historical stimulations method,the VaR for a portfolio is estimated by creating
hypothetical time series of returns on that portfolio which is obtained by running the portfolio
through the actual historical data and compute the changes that would have occured in each
period. Under this approach, it takes the market data for the last 250 days and calculates the
percent change for each risk factor on each day. Each percentage change is the multipled by
todays market values to represent 250 scenarios for tomorrows value. For each of these
scenarios, the portfolio is value using full, nonlinear pricing models. The third worst day is
the selected as being 99% VaR.

Where:

VaR (1 ) is the estimated VaR at the confidence level 100 (1 )%.

(R) is the mean of the series of simulated returns or P&Ls of the portfolio
R

is the worst return of the series of simulated P&Ls of the portfolio or, in other

words, the return of the series of simulated P&Ls that corresponds to the level of
significance

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Advantages of historical stimulation are it is easy to publicize the results throughout the
organization because the concepts are easily explained. Next, there is no need to assume that
the changes in the risk factors have a structured parametric probability distribution. Besides
that, in historical stimulation, it does not contain the estimation of any statistical parameters
such as variance or covariance and is consequently exempt from predictable estimation errors.
Their disadvantages are, it is very challenging to achieve as it in purest form and also it
requires data on all risk factors to be available over a reasonably long historical period in
order to give a good representation in future. Next, in this approach, as it does not include
distributional assumptions, the scenarios that are used in computing VaR are limited to those
that occured in the historical sample.
Monte Carlo Stimulation
This method measure VaR by creating many scenarios for future rates randomly by using the
nonlinear pricing models to estimates the change in value for each scenario, and the calculate
the VaR by referring to the worst losses. As compared to historical simulation where the
measurements carried out using the real observed changes in the market place over the last X
period to produce Y hypothetical portfolio profit or losses, but this Monte Carlo used random
number generator to generate tens of thousands of hypothetical changes in the mareket. These
are then are used to construct thousands of hypothetical profits and losses on the current
portfolio.

Where:

Ri is the return of the stock on the ith day

Si is the stock price on the ith day

Si+1 is the stock price on the i+1th day

is the sample mean of the stock price

is the timestep

is the sample volatility (standard deviation) of the stock price

is a random number generated from a normal distribution

2

BWRR3063 FINANCIAL RISK MANAGEMENT

At the end of this step/day (

= 1 day), we have drawn a random number and determined

Si+1 since all other parameters can be determined or estimated

The advantages of this method are, the estimation is accurate for non-linear instruments.
Next, it will be easy to get full distribution of potential portfolio and its not just a specific
percentile. Besides that, various distributional assumptions can be used like normal and Tdistribution to construct the portfolio.
The disadvantages are, this method takes a lot computational power and longer time to
estimate the results. In addition, unlike historical VaR, this approach requires the assumptions
that the risk factors have a Normal distribution.
Variance-covariance method.
This Variance-covariance method is an analytic technique where the distributional assumption
is made by assuming the daily geometric returns of the market variables are multivariate and
normally distributed with mean return zero. The method is linear in that changes in instrument
values are assumed to be linear with respect to changes in risk factors. By using historical
data, parameters like mean and standard deviation of the distribution are calculated and make
necessary projections with these use of these parameters.
Wher
e:

is the weighting of the first asset

is the weighting of the second asset

is the standard deviation or volatility of the first asset

is the standard deviation or volatility of the second asset

is the correlation coefficient between the two assets

Where:

VaR (1 ) is the estimated VaR at the confidence level 100 (1 )%.

represents the no. of standard deviations on the left side of the mean, at the
required standard deviation.

BWRR3063 FINANCIAL RISK MANAGEMENT

The advantage of this method is, it is fast and simple to calculate compare to Monte Carlo
and historical stimulation while the disadvantage is it is less accurate for non-linear portfolio.
References
Analytical Approach to Calculating VaR (Variance-Covariance Method. (n.d.). Retrieved

from financetrain.com: http://financetrain.com/analytical-approach-to-calculating-varvariance-covariance-method/

Calculating VaR Using Historical Simulation. (n.d.). Retrieved from financetrain.com:
http://financetrain.com/calculating-var-using-historical-simulation/
Calculating VaR using Monte Carlo Simulation. (n.d.). Retrieved from financetrain.com:
http://financetrain.com/calculating-var-using-monte-carlo-simulation/
Mria Bohdalov. (2007). A comparison of ValueatRisk methods for measurement.
Retrieved from casa.com: http://www.g-casa.com/PDF/Bohdalova.pdf
Terpezan Tabr Olga Alexandra. (n.d.). THE IMPORTANCE OF VALUE AT RISK METHOD
IN THE MANAGEMENT OF BANKING RISK.

Retrieved from asecu.gr:

www.asecu.gr/files/RomaniaProceedings/64.pd
VALUE

AT

RISK

(VAR).

(n.d.).

Retrieved

from

stern.nyu.edu:

http://people.stern.nyu.edu/adamodar/pdfiles/papers/VAR.pdf
Zhou Xinzi, O.-Y. Z. (2013, February). Introduction to Value-at-Risk (VaR). Retrieved from
ntu.edu.sg:

http://clubs.ntu.edu.sg/rms/researchreports/Introduction%20to%20Value-

at-Risk.pdf