MAT 4376 Mathematical Foundations of Risk Management - Lecture

Notes

January 19, 2020

1 Review of probability
1.1 Distribution. Tail distribution
Assume that X is a random variable with the cumulative distribution function (CDF) FX (x) =
P(X ≤ x) and the density fX (x) = F 0 (x). Then
Z x
F (x) = fX (u)du .
−∞

Definition 1.1 (Tail distribution function (TDF))

F̄X (x) = 1 − FX (x) = P (X > x) .

The cumulative distribution function is:

• nondecreasing;
• right continuous, with left limits;
• F (x) ∈ (0, 1);
• limx→∞ F (x) = 1, limx→−∞ F (x) = 0.
We will say that X is continuous if its CDF is the density fX exists. For calculation of inverses we
will often assume that additionally the CDF is continuous and strictly increasing.

1.2 Basic distributions and densities

Exponential: We say that a random variable X is Exponential with parameter λ > 0 if its density
is given by

0, x<0
fX (x) = . (1)
λ exp(−λx) , x ≥ 0

1
The distribution function of X is

0, x<0
FX (x) = P (X ≤ x) = .
1 − exp(−λx) , x ≥ 0

Thus, the tail distribution function of X is


1, x<0
F̄X (x) = .
exp(−λx) , x ≥ 0

Pareto: We say that a random variable X is Pareto with parameter α > 0 if its density is given by

αx−α−1 , x ≥ 1 ,

fX (x) = . (2)
0, x<1.

The distribution function of X is

Z x 
0, x<1
FX (x) = P (X ≤ x) = f (x) dx = . (3)
−∞ 1 − x−α , x ≥ 1

Thus, the tail distribution function of X is

Z x 
1, x<1
F̄X (x) = P (X ≤ x) = f (x) dx = .
−∞ x−α , x ≥ 1

This is an example of a heavy-tailed distribution.

Normal: We say that a random variable X is Normal with mean µ and variance σ 2 if its density is
given by
1
exp −(x − µ)2 /(2σ 2 ) , −∞ < x < ∞ .


fX (x) = √
2πσ
If µ = 0 and σ = 1 then we have the standard normal density denoted by φ(x). In this case the CDF
is denoted by Φ(x).

t (Student): We say that a random variable X has t distribution with α degrees of freedom if its
density is given by
− α+1
x2

Γ((α + 1)/2) 2
fX (x) = √ 1+ , −∞ < x < ∞ .
απΓ(α/2) α
Note that, similarly to Pareto distribution, we have
fX (x)
lim ∈ (0, ∞) .
x→∞ x−α−1
Thus, it is also an example of a heavy-tailed distribution.

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1.3 Expected value
For a random variable X with a density fX the expected value is calculated as
Z ∞
E[X] = xfX (x) dx .
−∞

If X is a nonnegative random variable with the cumulative distribution function FX then there is an
alternative formula: Z ∞
E[X] = F̄ (x)dx .
0

Example 1.2 • If X is Pareto, then using (2) we obtain if α > 1

Z ∞ Z ∞
α
E[X] = xfX (x) dx = α x−α dx = .
−∞ 1 α−1

• If X is Exponential, then using (1) we obtain

Z ∞ Z ∞
1
E[X] = xfX (x) dx = λ x exp(−λx) dx = .
−∞ 0 λ

1.4 Distribution and density of a transformation

Let X be a random variable with the CDF FX and density fX . Let g be a function. What is the CDF
and the density of Y = g(X)?

Y = X + a: We calculate

FY (y) = P (Y ≤ y) = P (X + a ≤ y) = P (X ≤ y − a) = FX (y − a) .

Taking the derivative we get the density of Y :

fY (y) = fX (y − a) .

Example 1.3 • If X is Pareto, then using (3) we obtain


0, y−b<1
FY (y) = P (Y ≤ y) = P (X + b ≤ y) = P (X ≤ y − b) = −α .
1 − (y − b) , y − b ≥ 1

Taking the derivative we get the density of Y :


0, y <b+1
fY (y) = −α−1 .
α(y − b) , y ≥b+1

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Y = exp(X) Since Y ≥ 0, we have P (Y ≤ y) = 0 for y ≤ 0. We calculate for y > 0:

FY (y) = P (Y ≤ y) = P (exp(X) ≤ y) = P (X ≤ log(y)) = FX (log(y)) .

Taking the derivative we get the density of Y :

1
fY (y) = fX (log(y)) . (4)
y
Example 1.4 • Assume that X is exponential. Then the CDF of Y = exp(X) is
 
0, log(y) < 0 0, y<1
FY (y) = −λ = −λ−1 (5)
1 − exp(−λ log(y)) = 1 − y log(y) > 0 λy , y≥1

The density of Y = exp(X) is

λ
fY (y) = exp(−λ log(y)) = λy −λ−1 , y > 1 . (6)
y
Note that we get Pareto.

Y = log(X): Note that we need that X is nonnegative (e.g. Pareto, exponential). We calculate

FY (y) = P (Y ≤ y) = P (log(X) ≤ y) = P (X ≤ exp(y)) = FX (exp(y)) . (7)

Taking the derivative we get the density of Y :

fY (y) = exp(y)fX (exp(y)) . (8)

Example 1.5 • If X is Pareto, then using (3) we obtain


0, exp(y) < 1
FY (y) = P (Y ≤ y) = P (log(X) ≤ y) = P (X ≤ exp(y)) = .
1 − exp(−αy) , exp(y) ≥ 1
Thus 
0, y<0
FY (y) = .
1 − exp(−αy) , y ≥ 0
Taking the derivative we get

0, y<0
fY (y) = .
α exp(−αy) , y ≥ 0

Alternatively, we could use the formula (2). For y > 0:

fY (y) = exp(y)fX (exp(y)) = exp(y)α(exp(y))−α−1 = α exp(−αy) .

Note that starting with X Pareto, the transformation Y = log X leads to exponential random
variable.

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Y = X 2: If X is nonnegative, then for x < 0, P (X 2 < x) = 0, while for x ≥ 0,
√ √
P (X 2 ≤ x) = P (X ≤ x) = FX ( x) .

The density of Y = X 2 is
1 √
fY (x) = √ fX ( x) .
2 x
√
Example 1.6 • Assume that X is Exponential. Then P (X 2 ≤ x) = 1 − exp(−λ x), x > 0. Thus,
for Y = X 2 , 
0. x<0
FY (x) = √ .
1 − exp(−λ x) , x ≥ 0

• Assume that X is Pareto. Then


0. x<1
FY (x) = −α/2 .
1−x , x≥1

Y = X 2: If X is not nonnegative (like normal), then for x < 0, P (X 2 < x) = 0, while for x ≥ 0,
√ √ √ √
P (X 2 ≤ x) = P (− x < X ≤ x) = FX ( x) − FX (− x) .

The density of Y = X 2 is
1  √ √
fY (x) = √ fX ( x) + fX (− x) .
2 x

1.5 Distribution for some special operations

Assume that X is a nonnegative random variable with the cumulative distribution function FX and
density fX . For b > 0 define

X − b if X > b ,
Y = (X − b)+ =
0 if X ≤ b .

We note that the resulting random variable has no density, since there is a positive mass at some point.
This means that the cumulative distribution function has a jump at that point.
By the definition Y ≥ 0. Therefore, P (Y ≤ y) = 0 for all y < 0. For y = 0 we have

P (Y ≤ 0) = P (Y = 0) = P (X ≤ b) = FX (b) .

Moreover, for y > 0,

P (Y ≤ y) = P (Y ≤ y, X ≤ b) + P (Y ≤ y, X > b) = P (0 ≤ y, X ≤ b) + P (X − b ≤ y, X > b)
= P (X ≤ b) + P (b < X ≤ y + b) = P (X ≤ b) + P (X ≤ y + b) − P (X ≤ b)
= P (X ≤ y + b) = FX (y + b) . (9)

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In summary

 0, y<0
FY (y) = FX (b) , y=0 . (10)
FX (y + b) , y > 0


Note that the cumulative distribution function has the jump of size P (X ≤ b) at point y = 0.

Example 1.7 • If X is Exponential then


 0, y<0
FY (y) = 1 − exp(−λb) , y=0 .
1 − exp(−λ(y + b)) , y > 0


• Assume that X is Pareto. We have to be careful about the value of b. Consider two cases: b < 1
and b > 1. See Assignment 1.
R∞
Expected value. We have the general formula for E[h(X)] = −∞ h(x)fX (x)dx. We use it with the
function h(x) = (x − b)+ which equals (x − b) if x > b and zero otherwise. We have
Z ∞ Z b Z ∞
E[(X − b)+ ] = (x − b)+ fX (x)dx = 0 × fX (x)dx + (x − b)fX (x)dx
−∞ −∞ b
Z ∞ Z ∞ Z ∞
= xfX (x)dx − b fX (x)dx = xfX (x)dx − bF̄X (b) .
b b b

In summary
Z ∞
E[(X − b)+ ] = xfX (x)dx − bF̄X (b) .
b

Example 1.8 Assume that X is Exponential.

Z ∞
E[(X − b)+ ] = λ x exp(−λx)dx − b exp(−λb)
b
1 ∞
 Z 
1
= λ − x exp(−λx) |∞ b + exp(−λx)dx − b exp(−λb)
λ λ b
 
1 1 1
=λ b exp(−λb) + 2 exp(−λb) − b exp(−λb) = exp(−λb) .
λ λ λ

Thus
1
E[(X − b)+ ] = exp(−λb) .
λ

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1.6 Inverse function. Quantile function.
Definition 1.9 Given a non-decreasing function T : R → R, the generalized inverse of T is T ← (y) :=
inf{x ∈ R : T (x) ≥ y}.

Definition 1.10 Given a distribution function F , the generalized inverse F ← is called the quantile
function of F .

If F is continuous and strictly increasing then the generalized inverse is just the usual inverse obtained
by solving y = F (x) for x. In this case we will write F −1 instead of F ← . Note that in this case

F −1 (F (y)) = F (F −1 (y)) = y .

In general
F ← (F (y)) 6= F (F ← (y)) 6= y .

Example 1.11 • For F (x) = 1 − exp(−λy) the quantile function is

1
F −1 (y) = − log(1 − y) , y ∈ [0, 1) .
λ

Inverse function for transformations. Assume that X is random variable with the CDF FX . If
Y = h(X) and you want to find FY← then you proceed as follows:

1. Calculate FY in terms of FX ;

2. Use the previous calculation to express FY← in terms of FX← .

Y = log(X) Assume that X is a continuous and nonnegative random variable with the cumulative
distribution function FX that is strictly increasing. Then we know from (7) that

FY (x) = P (Y ≤ x) = FX (exp(x)) .

Next, solve FX (exp(x)) = y:

FX (exp(x)) = y ,
exp(x) = FX−1 (y) ,
x = log(FX−1 (y)) .

Thus, the inverse function is FY−1 (y) = log(FX−1 (y)).

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2 Risk measures
Definition 2.1 (Coherent Risk Measure) Let ρ be a risk measure. Let X, Y be random variables,
and let c ∈ R, t ≥ 0. We say that ρ is a coherent measure of risk if it satisfies the following four
properties.

1. Monotonicity: For X ≤ Y we have ρ(X) ≤ ρ(Y ).

2. Homogeneity of degree 1 (Linearity): ρ(tX) = tρ(X).

3. Translation - Invariance: ρ(X + c) = ρ(X) + c.

4. Sub-Additivity: ρ(X + Y ) ≤ ρ(X) + ρ(Y ).

2.1 Value-At-Risk
Definition 2.2 Let X be a loss variable with the distribution function FX . Given a probability p ∈
(0, 1), the Value-At-Risk of the loss variable X at the level p is given by the smallest number x such
that the probability that loss X exceeds x is no larger than p:

VaRX (p) = inf{x ∈ R : P (X > x) ≤ p} = FX← (1 − p) .

We will show that VaR satisfies properties 1-3 of Definition 2.1. In what follows we shall assume that
the corresponding cumulative distribution functions are continuous and strictly increasing.

Lemma 2.3 The Value-At-Risk satisfies properties 1-3 of Definition 2.1.

Proof. Let X, Y be non-negative random variables with cumulative distribution functions FX and FY ,
respectively.

1. Let X ≤ Y . Then for x ∈ R we have FX (x) ≥ FY (x). This implies FX← (x) ≤ FY← (x). Setting
x = 1 − p we obtain the definition of VaR and therefore we conclude VaRX (p) ≤ VaRY (p) for
p ∈ (0, 1).
−1
2. We write VaRtX (p) = FtX (1 − p). We can also write the following relation:

(∗) (∗∗)
FtX (x) = FX (x/t) = 1 − p .
−1
From relation (*) we can conclude that x = FtX (1 − p). From relation (**) we can conclude that
− −
FX 1(1 − p) = x/t. This implies x = tFX 1(1 − p). Combining (*) and (**) together we get the
result:
VaRtX (p) = tVaRX (p) ,
as needed.

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 3. We write
(∗∗∗) (∗∗∗∗)
FX+c (y) = FX (y − c) = 1 − p .
−1
From relation (***) we can conclude that y = FX+c (1 − p) and from relation (****) we can
−1 −1
conclude that y − c = FX (1 − p). This implies y = FX (1 − p) + c. Combining these expressions
we get the result:
VaRX+c (p) = VaRX (p) + c ,
as needed.

However, as we will argue later, the Value-At-Risk is not a coherent risk measure, since in general
it is not sub-additive.

Example 2.4 Let X be Pareto random variable with parameter α. We have

1
VaRX (p) = p− α .

Example 2.5 Let X be exponential random variable with parameter λ. We have

log(p)
VaRX (p) = − .
λ

Example 2.6 Let X be normal with mean µ and variance σ 2 . Let Φ be the standard normal distribu-
tion. Fix p ∈ (0, 1). We have
VaRX (p) = µ + σΦ−1 (1 − p) .

2.2 Expected Shortfall

Definition 2.7 Let X be a loss variable with the distribution function FX such that E(|X|) < ∞. Given
a probability p ∈ (0, 1), the Expected Shortfall of the loss variable X at the level p is given by the

ESX (p) = E[X|X > VaRX (p)] .

Lemma 2.8 Assume the CDF of X is continuous and strictly increasing. The expected shortfall can
be calculated as
1 1
Z
ESX (p) = VaRX (1 − u)du .
p 1−p

Proof. The goal is to show

Z 1
1
E[X|X > VaRX (p)] = VaRX (1 − u)du .
p 1−p

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We have
E[XI{X > VaRX (p)}]
E[X|X > VaRX (p)] =
P (X > VaRX (p))
1 ∞
Z
1
= E[XI{X > VaRX (p)}] = xfX (x)dx
p p VaRX (p)
1 1 1 1
Z Z
−1
= F (u)du = VaRX (1 − u)du .
p 1−p X p 1−p
We used substitution x = FX−1 (u) and the property FX (FX−1 (x)) = x, valid since FX is strictly increasing
and continuous.
We can use both formulas for ESX , whatever is more convenient.
Example 2.9 Let X be Pareto random variable with parameter α. We have when α > 1
E[XI{X > y}] α
E[X|X > y] = = y.
F̄X (y) α−1
Hence, if α > 1, then ESX (p) is
α −1
ESX (p) = E[X|X > VaRX (p)] = p α .
α−1
Example 2.10 Let X be exponential random variable with parameter λ. Then
R∞ −λx dx
E[XI{X > y}] y λxe
E[X|X > y] = =
F̄ (y) e−λy
ye−λy + λ1 e−λy 1
= =y+ .
e−λy λ
Therefore,
1 − log(p)
ESX (p) = .
λ
Example 2.11 Let Z be standard normal. Then
φ(Φ−1 (1 − p))
ESZ (p) = .
p
Indeed, using a change of variables u = Φ(y) and du = φ(y)dy it is easy to calculate:
1 1 1 1 −1
Z Z
ESZ (p) = VaRZ (1 − u)du = Φ (u)du
p 1−p p 1−p
1 ∞
Z
= yφ(y)dy .
p Φ−1 (1−p)
You are asked to finish the computation in Assignment 2. Now, let X = µ+σZ. Then use the coherency
properties of ESX . See Assignment 2.

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We will show for Expected Shortfall that it is indeed a coherent measure. Properties 1-3 will follow
directly from the results of Value-at-risk.

Lemma 2.12 The Expected Shortfall satisfies properties 1-4 of Definition 2.1.

Proof. Let X, Y ≥ 0 and p ∈ (0, 1).

1. Let X ≤ Y . Since VaR satisfies Property 1, we have

1 1 1 1
Z Z
ESX (p) = VaRX (1 − u)du ≤ VaRY (1 − u)du = ESY (p) .
p 1−p p 1−p

2. See Assignment 2.

3. See Assignment 2.

4. We will show that

(ESX (p) + ESY (p) − ESX+Y (p)) ≥ 0 .
Assume for simplicity that X, Y are positive and continuous random variables. We will use the
following facts to help prove this property:

1.

E[I{X ≥ VaRX (p)}] = P (X ≥ VaRX (p)) = p , (11)

2. E[XI{X ≥ VaRX (p)}] = pESX (p)

We write,

p(ESX (p) + ESY (p) − ESX+Y (p))

= E[XI{X ≥ VaRX (p)}] + E[Y I{Y ≥ VaRY (p)}] − E[(X + Y )I{(X + Y ) ≥ VaRX+Y (p)}] .

Define
M = (X − VaRX (p))(I{X ≥ VaRX (p)} − I{(X + Y ) ≥ VaRX+Y (p)}) .
We will show E[M ] ≥ 0. We have

(i) If X > VaRX (p) then we have I{X ≥ VaRX (p)} = 1 and by definition, I{(X + Y ) ≥ VaRX+Y (p)} ∈
[0, 1] which implies M ≥ 0.
(ii) If X < VaRX (p) then we have I{X ≥ VaRX (p)} = 0 and we have M ≥ 0.
(iii) If X = VaRX (p) then M = 0.

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 By (11) we can calculate

VaRX (p)E[(I{X ≥ VaRX (p)} − I{(X + Y ) ≥ VaRX+Y (p)})] = VaRX (p)(p − p) = 0 .

We have determined that

E[M ] = E[(X − VaRX (p))(I{X ≥ VaRX (p)} − I{(X + Y ) ≥ VaRX+Y (p)})] ≥ 0 .

This implies that

E[X(I{X ≥ VaRX (p)} − I{(X + Y ) ≥ VaRX+Y (p)})] ≥ 0 .

Similarly for Y ,

E[Y (I{Y ≥ VaRY (p)} − I{(X + Y ) ≥ VaRX+Y (p)})] ≥ 0 .

We conclude that

p(ESX (p) + ESY (p) − ESX+Y (p))

= E[XI{X ≥ VaRX (p)}] + E[Y I{Y ≥ VaRY (p)}] − E[(X + Y )I{(X + Y ) ≥ VaRX+Y (p)} ≥ 0 .

Thus, Property 4 is satisfied.

Since all four properties are satisfied we conclude that Expected Shortfall is indeed a coherent risk
measure.

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