INTRODUCTION TO ENTERPRISE RISK MANAGEMENT

Book 2: Valuation And Risk Model

CHAPTER 2: MEASURES OF VaR

Exercise 2.1: Historical Simulation Method

You have accumulated 100 daily returns for your $100,000,000 portfolio. After ranking
the returns from highest to lowest, you identify the lowest six returns:

-0.0011, -0.0019, -0.0025, -0.0034, -0.0096, -0.0101

Calculate daily value at risk (VaR) at 5% significance using the historical method

Exercise 2.2: Monte Carlo Simulation Method:

A Monte Carlo output specifies the expected 1-week portfolio return and standard
deviation as 0.00188 and 0.0125, respectively. Calculate the 1-weekVaR at 1%
significance.

Exercise 2.3: CalculatingVaR using historical simulation

Calculate VaR of the 5th percentile using historical simulation and the data provided:

Figure 6: Historical Simulation Example

Histarical 𝐻𝑆
Six Lowest Simulation Cumulative
Returns Weight
Weight
−4.70% 0.01 0.0100
−4.10% 0.01 0.0200
−3.70% 0.01 0.0300
−3.60% 0.01 0.0400
−3.40% 0.01 0.0500
−3.20% 0.01 0.0600

Exercise 2.4: Calculatingweight using the hybrid approach

Suppose an analyst is using a hybrid approach to determine a 5% VaRwith the most

recent 100 observations (K = 100) and λ= 0.96 using the data in Figure 7. Note that
the data in Figure 7 are already ranked as described in Step 2 of the hybrid approach.
Therefore, the six lowest returns out of the most recent 100 observations are listed in
Figure 7. The weights for each observation are based on the number of observations (K

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= 100) and the exponential weighting parameter (\ = 0.96) using the formula provided
in Step 1 .

Figure 7: Hybrid Example Illustrating Six Lowest Returns (where 𝐾 = 100 and 𝜆 =
0.96 )

Hybrid
Six Lowest \mathrm{Number of Hybrid
Rank Cumulative
Returns Past } Periods Weight
Weight* ∗

1 −4.70% 2 0.0391 0.0391

2 −4.10% 5 0.0346 0.0736

3 −3.70% 55 0.0045 0.0781

4 −3.60% 25 0.0153 0.0934

5 −3.40% 14 0.0239 0.1173

6 −3.20% 7 0.0318 0.1492

"Cumulative weights are slightly aff ected by rounding error.

Calculate the hybrid weight assigned to the lowest return, −4.70%.

Using the information in Figure 7, calculate the initial VaR at the 5th percentile using the
hybrid approach.

Exercise 2.5: Calculating revised VaR

Assume that over the next 20 days there are no extreme losses. Therefore, the six lowest
returns will be the same returns in 20 days, as illustrated in Figure 8. Notice that the
weights are less for these observations because they are now further away. Calculate
the revised VaR at the 5th percentile using the information in Figure 8.

Figure 8: Hybrid Example Illustrating Six Lowest Return After 20 Days (where 𝐾 =
100 and 𝜆 = 0.96 )

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Six Lowest Number of Past Hybrid Hybrid Cumulative
Rank
Returns Periods Weigbt Weight* ∗

1 −4.70% 22 0.0173 0.0173

2 −4.10% 25 0.0153 0.0325

3 −3.70% 75 0.0020 0.0345

4 −3.60% 45 0.0068 0.0413

5 −3.40% 34 0.0106 0.0519

6 −3.20% 27 0.0141 0.0659

"Cumulative weights are slightly affected by rounding error.

Multiple choice questions

1. Fat-tailed asset return distributions are most likely the result of time-varying:

A. volatility for the unconditional distribution.

B. means for the unconditional distribution.

C. volatility for the conditional distribution.

D. means for the conditional distribution.

2. The problem offat tails when measuringvolatility is least likely:

A. in a regime-switching model.

B. in an unconditional distribution.

C. in a historical standard deviation model.

D. in an exponential smoothing model.

3. Which of the following is not a disadvantage of nonparametric methods compared to

parametric methods?

A. Data is used more efficientlywith parametric methods than nonparametric methods.

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 INTRODUCTION TO ENTERPRISE RISK MANAGEMENT
B. Identifying market regimes and conditional volatility increases the amount of usable
data as well as the estimation error for historical simulations.

C. MDE may lead to data snooping or over-fitting in identifying required assumptions

regarding an appropriate kernal function.

D. MDE requires a large amount ofdata that is directly related to the number of
conditioning variables used in the model.

4. The lowest six returns for a portfolio are shown in the following table

What will the 5% VaR be under the hybrid approach? Assume each observation is a
random event with 50% to the left and 50% to the right ofeach observation.
A. -3.1O%.

B. -3.04%.

C. -2.96%.

D. -2.90%.

5. Which of the following statements is an advantage of the implied volatility method in

estimating future volatility? The implied volatility:

A. model reacts immediately to changing market conditions.

B. model is not model dependent.

C. is constant through time.

D. is biased upward and is therefore more conservative

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 INTRODUCTION TO ENTERPRISE RISK MANAGEMENT
Multiple choise question

1. A $100 million equity portfolio contains two equally weighted and uncorrelated
positions. The positions’ volatilities are 30% and 40% per annum. If their returns are iid
normal, which is nearest to the 10-day 95% value at risk if assume 250 trading days per
year?

a. $4.93 million

b. $6.58 million

c. $8.22 million

d. $17.41 million

2. You collected your bank's trading book's daily mark-to-market profit & loss (P&L) for
the last two years, which is 500 trading days. The ten worst losses were (in millions,
losses as positives): 18.0, 15.0, 15.0, 13.0, 9.0, 9.0, 8.0, 7.0, 6.0, 5.0. What is the historical
99.0% confident daily expected shortfall (ES; aka, conditional VaR or expected tail loss)?

a. $9.0 million

b. $10.5 million

c. $14.0 million

d. $16.5 million

3. A bond with a face value of $10.0 million has a one-year probability of default (PD) of
1.0% and an expected recovery rate of 35.0%. What is the bond's one-year 99.0%
expected shortfall (ES; aka, CVaR)?

a. $3.25 million

b. $6.5 million

c. $9.1 million

d. Not enough information: need the tail distribution

4. A portfolio contains two independent (i.i.d.) and very risky bonds, each with identical
face values of $15.0 million, one-year default probabilities (EDF) of 10.0% and loss given
default (LGD) of 65.0%. What is the two-bond portfolio's one-year 99.0% expected
shortfall (ES)?
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a. $3.25 million

b. $8.67 million

c. $15.00 million

d. $19.50 million

5. Over the next year, a operational process model predicts an 95% probability of no
loss occurrence and a 5% probability of a single loss occurrence. If the single loss occurs,
the severity is characterized by three possible outcomes: $10.0 million loss with 20%
probability, $18.0 million loss with 50% probability, and $25.0 million loss with 30%
probability. What is the model's one-year 90% expected shortfall (ES)?

a. $9.25 million

b. $10.00 million

c. $13.88 million

d. $18.50 million

Practice Questions in textbook

2.11 A portfolio consists of 100 shares worth USD 20 each and 200 shares worth USD
30 each. What is the change in the value of the portfolio (in USD) as a function of the
change in share prices (in USD)?

2.12 In the situation in Question 2.11, what is the change in the value of the portfolio (in
USD) as a function of the returns (i.e., the percentage change in share prices)?

2.13 Suppose that the portfolio in Table 2.1 depends on a stock index. The value of the
stock index on Days 0, 1,2, 498, 499, and 500 is 1900, 1930, 1890, 2200, 2250, 2275,
respectively. What is the value of the stock index in the corresponding Day 501
scenarios 1, 2, 499, and 500?

2.14 Suppose that the portfolio in Table 2.1 depends on another credit spread. The value
of the credit spread on Days 0, 1,2, 498, 499, and 500 is (in basis points) 190, 195, 205,
170, 172, 176, respectively. What is the value of the credit spread in the corresponding
Day 501 scenarios 1,2, 499, and 500?

2.15 How would you estimate the 99.5% VaR from Table 2.3?
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2.16 Consider a position consisting of a USD 10,000 investment in asset X and a USD
20,000 investment in asset Y. Assume that the daily volatilities of X and Y are 1% and
2% and that the coefficient of correlation between their returns is 0.3. What is the five-
day VaR with a 97% confidence level?

2.17 In the situation in Question 2.16, what is the five-day expected shortfall with a 97%
confidence level?

3.11 A stock price (USD) is 50 and the volatility is 2% per day. Estimate a 95%
confidence interval for the stock price at the end of one day.

3.12 A company uses EWMA to estimate volatility day-by-day. What would be the
general effect of changing the volatility parameter from 0.94 to (a) 0.84 and (b) 0.98?

3.13 Suppose that the observations on a stock price (in USD) at the close of trading on
15 consecutive days are 40.2, 40.0, 41.1, 41.0, 40.2, 42.3, 43.1, 43.4, 42.9, 41.8, 43.7, 44.3,
44.4, 44.8, and 45.1. Estimate the daily volatility using Equation (3.1).

3.14 Suppose that the price of an asset at the close of trading yesterday was USD 20 and
its volatility was estimated as 1.4% per day. The price at the close of trading today is
USD 19. What is the new volatility estimate using the EWMA with a A of 0.9?
3.15 If co = 0.000002, a = 0.04, and (3 = 0.94 in a GARCH model.

1. what is the long-run average variance rate? What volatility does this correspond to?

2. Repeat Question 3.14 using the GARCH (1,1) model

3.17 Suppose that the current volatility estimate is 3% per day and the long-run average
volatility estimate is 2% per day. What are the volatility estimates in ten days and 100
days in a GARCH (1,1) model where co = 0.000002, a = 0.04, and (3 = 0.94?

3.18 Delete scenario number 490 from Table 3.3 so that the worst scenario is scenario
492 with a loss of USD 6.5.

1. What is the new VaR?

2. what is the new 99% expected shortfall estimate?

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3.20 Suppose that the price of asset X at the close of trading yesterday was USD 40 and
its volatility was then estimated as 1.5% per day. Suppose further that the price of asset
Y at the close of trading yesterday was USD 10 and its volatility was then estimated as
1.7% per day. The price of X and Y at the close of trading today are USD 38 and USD 10.1,
respectively. The correlation between X and Y was estimated as 0.4 at the close of
trading yesterday. Update the volatility of X and Y and the correlation between X and Y
using the EWMA model with A equal to 0.95

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