ACTSC 445/845: Quantitative Risk Management

Fall 2022

Erik Hintz
Department of Statistics and Actuarial Science
erik.hintz@uwaterloo.ca

Lecture 04

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 Today’s Agenda

Last time:

Brief review
Another example for the mapping framework
Risk measurement

Today (Lec 4, 09/19):

Two very important risk measures:

I Value-at-risk
I Expected shortfall

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 Review

What is the mathematical definition of a risk measure?

What is the interpretation of the numeric value returned by the risk
measure?
What three main approaches to risk measurement have we discussed?

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Chapter 2: Basic Concepts in Risk Management

2.3. Risk Measurement

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 Risk measures based on loss distributions

We are now studying the two (probably) most prominent examples for risk
measures that are based on loss distributions: Value-at-risk and Expected
Shortfall.
Before defining the Value-at-risk for a loss L, we need a technical tool, namely
the generalized inverse:

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 Interlude: Generalized Inverses

For any function T , we say that T is increasing if T (x ) ≤ T (y ) for all x < y

We say that T is strictly increasing if T (x ) < T (y ) for all x < y .
Definition
For any increasing function T : R → R, the generalized inverse
T ← : R → R := R ∪ {−∞, ∞} of T is defined by

T ← (y ) = inf {x ∈ R : T (x ) ≥ y }, y ∈ R

where inf ∅ := ∞.
If T is a cdf, then T ← : [0, 1] → R is the quantile function of T .

This definition generalizes the definition of an inverse function:

Remark
If T is continuous and strictly increasing, then T ← = T −1 , the ordinary
inverse function.

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 Interlude: Generalized Inverses
Visualization:

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 Interlude: Generalized Inverses

There are many rules (and misconceptions!) for working with T ← . Rules are
often (not always!) the same as working with inverse functions T ← , see the
paper Embrechts and Hofert (2013): ”A note on generalized inverses”.
(https://doi.org/10.1007/s00186-013-0436-7)
Generalized inverses are very useful in modelling and simulation, among others:
Lemma
Let F be a distribution function and X ∼ F . Then
1) If F is continuous, F (X ) ∼ U[0, 1]
2) If U ∼ U[0, 1], then F ← (U ) ∼ F

Part 2) is referred to as inversion method: In order to simulate a realization of

X ∼ F , one simulates a uniform random number (i.e. U ∼ U[0, 1]) and plugs
that one into the quantile function.
Proof.
Proof of general case not required, but can be found in the reference above,
Prop. 3.1 therein. The special case where F is strictly increasing (i.e. when
F ← = F −1 ) is elementary and should be done as an exercise.

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 Value-at-risk

Definition (Value-at-risk)
For a loss L ∼ FL , the value-at-risk at confidence level α ∈ (0, 1) is defined by

VaRα = VaRα (L) = inf {x ∈ R : FL (x ) ≥ α} = FL← (α)

L is usually the loss over some time period ∆t (like Lt +1 from before)
VaRα is the α-quantile of FL
⇒ FL (x ) < α for all x < VaRα (L)
⇒ FL (VaRα (L)) ≥ α
Note

VaRα = inf {x ∈ R : FL (x ) ≥ α} = inf {x ∈ R : F L (x ) ≤ 1 − α}

where F L (x ) = 1 − FL (x )
VaRα is the smallest loss which is exceeded with probability at most 1 − α
Known since 1994: Weatherstone 415 report.
VaR is the most widely used risk measure (Basel II, Solvency II)

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 Value-at-risk

0.8
0.6
Density

0.4
0.2

2.5% mass
0.0

0 E(L) VaR0.975 ES0.975 4

Figure: VaR0.975 and ES0.975 for L ∼ Gamma(2, 2)

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 Interlude: The Normal and the t distribution

We say that Z ∼ N(0, 1) (standard normal) if Z has density

√ 2
φ(x ) := fZ (x ) = (1/ 2π )e −x /2 , x ∈ R
Rx
We denote the cdf of Z by Φ(x ) := FZ (x ) = P(Z ≤ x ) = −∞ φ(t )dt.
We have E(Z ) = 0 and Var(Z ) = 1.
If Z ∼ N(0, 1), then Y := µ + σZ ∼ N (µ, σ2 ) with density/cdf given by

fY (x ) = (1/σ)φ ((x − µ)/σ) , FY (x ) = Φ((x − µ)/σ), x ∈ R

We say that X ∼ tν := tν (0, 1) (standard t, where ν > 0 =

degree-of-freedom parameter) if X has density

Γ((ν + 1)/2) ν +1
ft ν ( x ) = √ (1 + x 2 /ν)− 2 , x ∈ R
νπΓ(ν/2)

If ν > 1, E(X ) = 0 (o.w. DNE) and if ν > 2, Var(X ) = ν− ν

2 (o.w. DNE)
2
If X ∼ tν , then W = µ + σX ∼ tν (µ, σ ). Same rules for finding pdf/cdf
apply here.

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 0.4
ν = Inf
ν=5
ν=1
ν = 0.5
0.3
Density

0.2
0.1
0.0

−5 0 5

Figure: Density plot of N(0, 1) and tν (0, 1) for different ν. The case ν = ∞
corresponds to a N(0, 1) distribution.

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 VaR for the normal and t-distribution

Example (VaR for the normal and t-distribution)

Let α ∈ (0, 1).
Let L ∼ N (µ, σ2 ). Then

VaRα (L) = µ + σ Φ−1 (α)

Let L ∼ tν (µ, σ2 ) for some ν > 0. Then

VaRα (L) = µ + σ t− 1
ν (α)

where tν (·) is the cdf of tν (0, 1).

Proof.
Whiteboard for N(µ, σ2 ) case, t case follows analogously (exercise).

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 Choices of parameters ∆t and α

Need to choose time horizon ∆t (L depends on ∆t) and confidence level

α ∈ (0, 1).
∆t should be such that portfolio unchanged over ∆t
∆t should be relatively small:
I more data available
I if Lt∆+1 used instead of Lt +1 , approximation better for small ∆t
Typical choices:
I For limiting traders: α = 0.95 and ∆t = 1d
I In Basel II:
Market risk: α = 0.99 and ∆t = 10d
Credit + operational risk: α = 0.999 and ∆t = 1y
I In Solvency II: α = 0.995 and ∆t = 1y
Backtesting often needs to be carried out at lower confidence levels in
order to have sufficient statistical power to detect poor models.
Be cautious with strictly interpreting VaRα (L) (and other risk measure)
estimates (considerable model/liquidity risk)

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 VaR in risk capital calculations

Daily risk capital formula in Basel II for banks using the internal model:
( )
k 60
60 i∑
t t,10 t −i +1,10
RC = max VaR0.99 , VaR0.99 +C
=1

VaRs,10
α = 10-day VaRα calculated at day s (t=today)
k ∈ [3, 4] stress factor
C > 0 is an additional charge:

C = stressed VaR charge + incremental risk charge + charges for specific risks

where the stressed VaR charge is calculated from volatile market data and
incremental risk charge is a VaR0.999 estimate of the annual losses due to
defaults/downgrades.
The averaging tends to lead to smooth changes in the capital charge over time
unless VaRt,10
0.99 is very large.

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 Discussion of VaR
Advantages
No assumptions on L (like
integrability)
Makes sense on all levels/across
portfolios
Interpretable / somewhat easy to
communicate
Widely used (can also be
disadvantage ⇒ risk
management herding)
VaR is elicitable (minimizes some
expected functional) ⇒ useful for
backtesting/comparing risk
measures.
Drawbacks
Not a what-if measure: No
information about the severity of
losses occurring with prob.
≤ 1 − α (⇒ only frequency
based)
Not subadditive and thus not
coherent (later): eg portfolio
L = L1 + L2 , then
VaR(L1 + L2 ) 6≤
VaR(L1 ) + VaR(L2 ) in general
⇒ no diversification benefits
⇒ makes decentralization of RM
difficult (aggregating VaR
numbers for different risks may
not give a bound of overall risk)
Easy interpretation can be
misleading (model+liquidity risk)
Difficult to estimate for large α
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 Expected Shortfall

We use the notation x+ = max{x, 0} = x · 1x ≥0

Definition
For a loss L ∼ FL with E(L+ ) < ∞ the expected shortfall at confidence level
α ∈ (0, 1) is defined as
Z 1
1
ESα = ESα (L) = VaRu (L)du
1−α α

ESα is the average of VaRu over all u ≥ α

⇒ ESα ≥ VaRα
Besides VaR most important risk measure in practice
Advantages and drawbacks will be discussed later.

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 Value-at-risk and Expected Shortfall

0.8
0.6
Density

0.4
0.2

2.5% mass
0.0

0 E(L) VaR0.975 ES0.975 4

Figure: VaR0.975 and ES0.975 for L ∼ Gamma(2, 2)

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 Expected Shortfall

There are also different formulas for ESα depending on properties of FL :

Proposition
If FL is continuous
ESα (L) = E(L | L > VaRα (L))

Thus, if FL is continuous, ESα is the conditional tail expectation, sometimes

also called conditional VaR.
Remark
If FL is discontinuous, this proposition cannot be applied. In this case,

E(L1{L>VaRα (L)} ) + VaRα (L) · (1 − α − F L (FL← (α)))

ESα (L) =
1−α

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 ES for the normal and t-distribution

Example (ES for the normal and t-distribution)

Let α ∈ (0, 1).
Let L ∼ N (µ, σ2 ). Then

φ Φ −1 ( α )


ESα (L) = µ + σ
1−α

Let L ∼ tν (µ, σ2 ) for some ν > 1. Then

2 !
ft t − 1 ( α ) ν + tν−1 (α)


ESα (L) = µ + σ ν ν
1−α ν−1

where tν (·) is the cdf of tν (0, 1) and ftν (·) is the density of tν (0, 1)

Proof.
Whiteboard for the normal case, the t case should be done as an exercise
(similar to the normal case).

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