VAR

 Marginal VAR

o Measures the change in VAR resulting from a small change in the

holding of one asset.
o Marginal VAR assumes a small change in the portfolio weight. For
larger changes, like from 67% to 50%, its only an approximation.

 Absolute VAR

o Provides a less measure relative to the initial wealth (W0)

 Relative VAR

o Is relative to expected future wealth, E(W).

 Component VAR

o Is the change in portfolio VAR resulting from deleting a given

component from the portfolio.

 Incremental VAR

o Incremental VAR measures how much VAR changes if some trade

is carried out.

 Nonparametric VAR

o We do not have to assume that returns are normally distributed

when using nonparametric VAR.

 Diversified VAR

o The portfolio VAR measure which takes correlations between

securities into account. (Normal VAR)

 Undiversified VAR

o The sum of the individual VAR numbers for the securities.

 LVAR

 The measure tries to capture the idea that after a price fall, there is the
additional risk that of one has to liquidate the stock position, this has to
be done at the bid price, and hence an additional loss compared to
liquidating at the “true price” (the mid price) will be incurred.

 The measure does not take into account that bid ask spreads could widen
in a time of distress and it does not allow for sequential liquidation of the
stock position.

BACKTESTING

 Testing using historical data.

 It involves testing how well the VAR would have performed in the past.

 Fat tails / jumps are often detected in backtesting when the VAR
calculation are done at 99% level, but not at 95% level.

 Type 1 Error

o Rejecting the null hypothesis when it is true.

 Type 2 Error

o Not rejecting the null hypothesis when it is false.

o Type II errors decrease with the number of observations.

o Type II errors increase as the VAR confidence level increases

BLACK-SCHOLES

 If volatility increases, asset substitution takes place.

 The value of equity increases since the call option becomes more valuable.
 The value of debt decreases since the value of assets is constant.

 Senior and Junior debt

o Credit spread.
  Since senior debt is always repaid in full before junior debt
receives any payments, senior debt is less risky and
therefore always has a smaller credit spread.

o Asset volatility changes

 If volatility increases, the value of senior debt decreases

since it can be viewed as riskless debt minus a put option,
and the put option becomes more valuable.

VOLATILITY

 Historical volatility

o Is the volatility that can be estimated from a time series of past

returns.

 Implied Volatility

o The implied volatility is forward looking in the sense that the

option price incorporates the markets expectation of future
volatility, which is also what the risk manager worries about when
computing the VAR.

o Empirical evidence suggests that implied volatilities forecast

better than historical volatilities. Limits:
 1: Options might not be traded
 2. Might be longer term options
 3. Implied volatility might differ from expected volatility
due to risk premium.

“Ghosting Effect”

 Happens when time-varying volatility is estimated from a moving average

of historical returns. If the moving average is based on M returns and
there was a large return M days ago, dropping this return as the window
moves 1 day forward will lower the volatility estimate.
 Old observations receive same weight as new. This leads to the “ghosting
effect”, the phenomenon that an extreme return on day t produces a
sudden drop in volatility on day t + M.

Various
 SWAP

o A credit default swap is a contract, which insures against default of

a particular bond issuer or a particular bond.

 The leverage effect

o When asset value falls, so does equity value. This increases the
leverage of the firm and this in turn increases volatility of equity.

 Pool

o In model 1 defaults are independent, while defaults are correlated

in model 2. Higher correlation for a given default probability
implies fatter tails, so the probability of more defaults is expected
highest in model 2.

 Historical data

o An estimator where data is backward looking.

 Netting agreement

o A netting agreement “nets out” all exposure between two parties in

the event of default of one of the parties before determining the
settlement amount.
o The idea is to avoid a situation in which the defaulting party
defaults on all claims which have negative value while obtaining
full payment of the claims which have positive value.

 Correlation in times of distress

o Correlations increase.

 Fatter tails

o Kurtosis describes the fatness of tails and a normal distribution

has kurtosis 3. If the estimated kurtosis for series is larger than 3 it
has fat tails.
o Expected tail loss at a given confidence level is the expected loss
given that the loss is greater than the VAR.