1

Bank Management
FINC 713
Assoc. Prof. Dr. Mona ElBannan
Department of Finance

Risk Management and Value in Banking

Lecture 5
Value at Risk Models: the parametric
approach
Part (2)
 2

Diversification & correlations

• VaR must be estimated for every single position and for
the portfolio as a whole

• This requires to “aggregate” positions together to get a

risk measure for the portfolio

• This can be done by:

– mapping each position to its market factors;
– estimating correlations between market
factors’ returns;
– measuring portfolio risk through standard
portfolio theory.

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Diversification & correlations

An example

Position (€ Worst case

Currency VaR (Euro)
mln) (1.65*std.dev.)
USD -50 0.92% 460.000
Yen 50 1.76% 880.000

Sum of VaRs: € 1,340,000

If correl. €/$-€/Yen = 0.54

VarTot  Var$2  VarYen

2
 2  Var$  VarYen   $,Yen 

 460m 2  880m 2  2  (460m)  880m  0.54  € 740,821

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Diversification & correlations

 Three main issues
1) A 2 positions portfolio VaR may be lower than the more
risky position VaR  natural hedge
2) Correlations tend to shoot up when market shocks/crises
occur  day-to-day RM is different from stress-testing/crises
mgmt
3) A relatively simple portfolio has approximately 250 market
factors  large matrices  computationally complex  an
assumption of independence between different types of market
factors is often made

VarTot  Var  Var  Var 2

FX
2
IR
2
Equity
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 5

Mapping stock portfolio

 Equity positions can be mapped to their stock index
through their beta coefficient
 In this case beta represents a sensitivity coefficient to
the return of the market index

 Individual stock VaR VaRi  MVi   i   j  

 N 
 Portfolio VaR VaR j    MVi   i    j  
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Mapping of a stock portfolio

Example
Mapping of equity positions
Stock A Stock B Stock C Portfolio
Market Value (EUR m) 10 15 20 45
Beta 1,4 1,2 0,8
Position in the Market Portfolio (EUR m) 14 18 16
Volatility 15% 12% 10%
Correlation with A 1 0,5 0,8
Correlation with B 0,5 1 0
Correlation with C 0,8 0 1

 N 
VaRP ,99%    MVi   i    j    48  0.07  2.326  7,817
 i 1 
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Mapping of a stock portfolio

Example with individual stocks volatilities and correlations
Mapping of equity positions
Stock A Stock B Stock C Portfolio
Market Value (EUR m) 10 15 20 45
Beta 1,4 1,2 0,8
Position in the Market Portfolio (EUR m) 14 18 16
Volatility 15% 12% 10%
Correlation with A 1 0,5 0,8
Correlation with B 0,5 1 0
Correlation with C 0,8 0 1

VaR P ,99%  VaR A2  VaR B2  VaRC2  2VaR AVaR B  A, B  2VaR AVaRC  A,C  2VaR BVaRC  B ,C  9,589

VaR of an equity portfolio

Volatilities &
Stock A Stock B Stock C Mapping Correlations
VaR(99%)
McGraw-Hill/Irwin 3.490 4.187 4.653 7.817 9.589
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Mapping of a stock portfolio

V
a
Ro
fa
ne
qu
i
t
y p
o
rt
f
oli
o
Vo
l
ati
l
it
ies&
St
ock
A S
t
ock
B S
t
ock
C M
a
pp
in
gCo
r
rel
a t
i
ons
V
a
R(
99
%) 3
.4
90 4
.1
87 4
.6
53 7
.
817 9.589

Mapping to betas:
 assumption of no specific risk
 the systematic risk is adequately captured by a CAPM type
model
 it only works for well diversified portfolios
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Example 1 – FX portfolio

• Assume we want to estimate the value at risk connected with

two currency positions, a long one in US dollars and a short
one in Japanese yens, with market values of 50 and 10 million
euros, respectively.
• In addition, assume that the daily volatility of log returns of
the two exchange rates, EUR/USD and EUR/YEN, is 2 % and
3 %, respectively, and that the correlation coefficient between
these returns is 0.6.
• The daily value at risk of the dollar exposure, measured with a
99.5 % confidence level

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Example 1– FX portfolio
• Solution:

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Example 2 - Volatility and Correlations –

Market Factors for a Forward Position

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Example 3 - Mapping of Stock Positions

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Example 3 - Mapping of Stock Positions

• We can compute VaR by two ways:

• – either by using mapping, i.e., considering the virtual
positions in the index and the latter’s volatility;
• – or without having recourse to mapping, i.e., considering the
actual positions and using three risk factors, corresponding to
the returns of stocks A, B, C.
• If mapping is used, the VaR of the portfolio comprising the
three stocks – based upon (5.27) – will be:

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Example 3 - Mapping of Stock Positions

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Questions & Exercises

1. An investment bank holds a zero-coupon bond with

a life-to-maturity of 5 years, a yield-to-maturity of
7% and a market value of 1 million €. The historical
average of daily changes in the yield is 0%, and its
volatility is 15 basis points. Find:
(i) the modified duration;
(ii) the price volatility;
(iii) the daily VaR with a confidence level of 95%,
computed based on the parametric (delta-normal)
approach

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Questions & Exercises

3. Using the parametric approach, find the VaR of the
following portfolio:
(i) assuming zero correlations;
(ii) assuming perfect correlations;
(iii) using the correlations shown in the Table

Asset VaR  (S,C)  (S,B) (C,B)

Stocks (S) 50.000 0,5 0 -0,2
Currencies (C) 20.000
Bonds (B) 80.000

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Questions & Exercises

5. The daily VaR of the trading book of a bank is 10 million

euros. Find the 10-day VaR and show why, and based on
what hypotheses, the 10-day VaR is less than 10 times the
daily VaR

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Questions & Exercises

6. Using the data shown in the following table, find the parametric VaR, with a
confidence level of 99%, of a portfolio made of three stocks (A, B and C), using the
following three approaches: (1) using volatilities and correlations of the returns on the
individual stocks; (2) using the volatility of the rate of return of the portfolio as a
whole (portfolio-normal approach) (3) using the volatility of the stock market index
and the betas of the individual stocks (CAPM). Then, comment the results and say why
some VaRs are higher or lower than the others.

Stock A Stock B Stock C Portfolio Market

index
Market value (€ million) 15 15 20 50 -
Beta 1.4 1.2 0.8 1.1 1
Volatility 15% 12% 10% 9% 7%
Correlation with A 1 0,5 0,8 - -
Correlation with B 0,5 1 0 - -
Correlation with C 0,8 0 1 - -
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Questions & Exercises

9. An Italian bank has entered a 3-months forward
purchase of Swiss francs against euros. Using the
market data on exchange rates and interest rates (simple
compounding) reported in the following Table, find the
positions and the amounts into which this forward
purchase can be mapped.

Spot FX rate EURO/SWF 0.75

3-month EURO rate 4.25%
3-month SWF rate 3.75%

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End of Chapter


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Reference

• Textbook: Andrea Sironi & Andrea Resti, Risk

Management and Value in Banking and
Insurance.

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