Riska Marketrisk p1

Khoa Toán Kinh tế
Risk analytics
Hoàng Đức Mạnh & Nguyễn Thị Liên

Trường Đại học Kinh tế Quốc dân
March 25, 2024
Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 1

CHAPTER 5. MARKET RISK

Learning objectives
Describe the mean-variance framework.

Explain the limitations of the mean-variance framework with respect
to assumptions about return distributions.
Define the VaR measure of risk, describe assumptions about return
distributions and holding period, and explain the limitations of VaR.
Explain and calculate Expected Shortfall (ES), and compare and
contrast VaR and ES.
Define the properties of a coherent risk measure and explain the
meaning of each property.

Learning objectives
Estimate VaR using a historical simulation approach.

Estimate VaR using a parametric approach for both normal and
lognormal return distributions.
Estimate the expected shortfall given P/L or return data.
Estimate risk measures by estimating quantiles.
Evaluate estimators of risk measures by estimating their standard
errors.
Interpret Q Q plots to identify the characteristics of a distribution.

MEASURES OF FINANCIAL RISK
THE MEAN-VARIANCE FRAMEWORK

The mean-variance framework uses the expected mean and standard
deviation to measure the financial risk of portfolios.
Example: Calculating Expected Return and Standard Deviation
Combinations of Investments: The portfolio expected return, The
variance of the portfolio return:
µ P = w1 µ 1 + w2 µ 2
σP2 = w12 σ12 + w22 σ22 + 2ρw1 w2 σ1 σ2

THE MEAN-VARIANCE FRAMEWORK

Limitations of the Mean-Variance Framework with Respect to
Assumptions about the Return Distributions:
If the return distribution is not symmetric, the standard deviation is not
a reliable or relevant measure of probabilities at the extreme ends of
the distribution.
The normality assumption is only strictly appropriate in the presence of
a zero-skew (symmetric) distribution. If the distribution leans to the
left or the right, (something that often happens with financial returns)
the mean-variance framework produces misleading risk estimates.
The standard deviation can be a perfect measure of risk, but it does
not capture the tails of the probability distribution.

VALUES AT RISK (VaR)

Value at Risk (VaR) can be defined as the maximum amount of loss,
under normal business conditions, that can be incurred with a given
confidence interval (over a given time period).
Suppose an analyst calculates the monthly VaR as $100 million at
95% confidence: What does this imply?
This simply means that under normal conditions, in 95% of the
months, we expect the fund to lose no more than $100 million.
Put differently, the probability of losing $100 million or more in any
given month is 5%.

VALUES AT RISK (VaR): The VaR with a confidence level of X% is found

by searching for the loss that has an X% chance of being exceeded.

VALUES AT RISK (VaR): Limitations of VaR

It does not describe the worst possible loss.
Example: Suppose that the VaR with a 99% confidence level is USD
20 million. We can imagine two situations.
If the loss is greater than USD 20 million (a 1% chance), it is
inconceivable that it will be greater than USD 30 million.
If the loss is greater than USD 20 million (a 1% chance), it is most
likely to be USD 100 million.
The VaR for both situations is USD 20 million, but the second
situation is clearly riskier than the first.

EXPECTED SHORTFALL (ES)

The expected shortfall, also known as the conditional VaR, is the
average of losses beyond the q% quantile (you can think about it as
the loss beyond the VaR).

COHERENT RISK MEASURE: A risk measure summarizes the entire

distribution of dollar returns X by one number, ρ(X ). There are four
desirable properties every risk measure should possess:
Monotonicity: if X1 ≤ X2 , ρ(X1 ) ≥ ρ(X2 ). If a portfolio has
systematically lower values than another, in each state of the world, it
must have greater risk.
Subadditivity: ρ(X1 + X2 ) ≤ ρ(X1 ) + ρ(X2 ). when two portfolios are
combined, their total risk should be less than (or equal to) the sum of
their individual risks; Merging of portfolio ought to reduce risk.

COHERENT RISK MEASURE:

Homogeneity: ρ(kX ) = kρ(X ). Increasing the size of a portfolio by a
factor k should result in a proportionate scale in its risk measure.
Translation invariance: ρ(X + h) = ρ(X ) − h. Adding cash � to a
portfolio should reduce its risk by �.

ESTIMATING MARKET RISK MEASURES
DATA
Profit/Loss Data: The P/L generated by an asset (or portfolio) over
the period t:
P/Lt = Pt + Dt − Pt−1
If data are in P/L form, positive values indicate profits and negative
values indicate losses.
Loss/Profit Data:
L/Pt = −P/Lt
L/P observations assign a positive value to losses and a negative
value to profits.

DATA
Arithmetic Return Data: The arithmetic return rt is defined as:
Pt + Dt − Pt−1
rt =
Pt−1
Geometric Return Data: The geometric return rt is

P + D
t t
rt = ln
Pt−1
The geometric return is often more economically meaningful than the

arithmetic return, because it ensures that the asset price (or portfolio
value) can never become negative regardless of how negative the
returns might be.

NON-PARAMETRIC APPROACHES: Historical Simulation

Historical simulation is a popular method of calculating VaR and ES.
In practice, risk factors are divided into two categories:
Those where the percentage change in the past is used to define a
percentage change in the future, and
Those where the actual change in the past is used to define an actual
change in the future.
Example (Valuation and Risk Models, p.18): Historical Data for
Example, Scenarios Created for the Example.



NON-PARAMETRIC APPROACHES: Historical Simulation-Estimating

VaR
The risk manager constructs a distribution of losses by subjecting the
current portfolio to the actual changes in the key factors experienced
over the last t time periods.
Important steps:
Order (sort) the daily profit/loss observations;
Find the [(1-CL%)*n+1]th highest observation.
If we have 1000 observations and a confidence level of 95%, the
VaR(95%) is given by the (1-0,95)*1000+1=51st observation.

NON-PARAMETRIC APPROACHES: Bootstrapped Historical Simulation

Bootstrapping presents a simple but powerful improvement over basic
HS to estimate VaR and ES.
A bootstrap procedure involves resampling from our existing data set
with replacement.
We start with a given original sample of size n.
We draw a new random sample of the same size from this original
sample, “returing” each chosen observation back in the sampling pool
after it has been drawn.
Sampling with replacement implies that some observations get chosen
more than one, and others don’t get chosen at all.


The resampling process is repeated many times over, resulting in a set
of resample parameter estimates.
In the end, the average of all the resample parameter estimates gives
us the final bootstrap estimate of the parameter.



Equally as important is the possibility to extend the key tenets of
bootstraps to estimation of the expected shortfall.
First, the tail region is sliced up to n slices and the VaR for each of
the resulting n-1 quantiles is determined.
The final VaR estimate is taken to be the average of all the tail VaRs.
We estimate the ES as the average of losses in excess of the final VaR.

NON-PARAMETRIC APPROACHES: Weighted HS Approaches

Recall that under the historical method of estimating VaR, all of the
past n observations are weighted equally, where each observation has
a weight of 1/n.
First, it seems hard to justify giving each observation the same weight
without taking into account age, market volatility at the time it was
observed.
Second, equal weights make the resulting risk estimates unresponsive
to major events: stock market crash.
Third, equal weights suggest that each observation in the sample
period is equally likely and independent of all the others.


Age-weighted HS: We could come up with a weighting structure that
discounts the older observations in favor of newer ones.
The weight given to an observation i days old is given by:
λi−1 (1 − λ)
w(i) =
1 − λn


Volatility- weighted HS: The basic idea— suggested by Hull and
White (HW; 1998b)— is to update return information to take
account of recent changes in volatility.
The volatility-adjusted return, rt,i
∗ , is
σT ,i
rt,i
∗
= rt,i
σt,i

NON-PARAMETRIC APPROACHES: Monte Carlo simulations

This approach is very similar to the use of historical simulations, but
with one key difference: Monte Carlo simulations generate scenarios
by taking random samples from the distributions assumed for the risk
factors (rather than using historical data).
Monte Carlo simulations work for both linear and non-linear portfolios.

NON-PARAMETRIC APPROACHES: ADVANTAGES OF

NON-PARAMETRIC METHOD
Non-parametric approaches are intuitive and conceptually simple.
Since they do not depend on parametric assumptions about P/L, they
can accommodate fat tails, skewness, and any other non-normal
features that can cause problems for parametric approaches.
They can in theory accommodate any type of position, including
derivatives positions.
There is a widespread perception among risk practitioners that HS
works quite well empirically, although formal empirical evidence on
this issue is inevitably mixed.


They are (in varying degrees, fairly) easy to implement on a
spreadsheet.
Non-parametric methods are free of the operational problems to
which parametric methods are subject when applied to
high-dimensional problem s: no need for covariance m atrices, no
curses of dimensionality, etc.
They use data that are (often) readily available, either from public
sources (e.g., Bloomberg) or from in-house data sets (e.g., collected
as a by-product of marking positions to market).


They provide results that are easy to report and communicate to
senior managers and interested outsiders (e.g., bank supervisors or
rating agencies).
It is easy to produce confidence intervals for non-parametric VaR and
ES
Non-parametric approaches are capable of considerable refinement
and potential im provem ent if we combine them with parametric
’add-ons’ to make them sem i-parametric: such refinements include
ageweighting (as in BRW), volatility-weighting (as in HW and FHS),
and correlation-weighting.


If our data period was unusually quiet, non-parametric methods will
often produce VaR or ES estimates that are too low for the risks we
are actually facing; and if our data period was unusually volatile, they
will often produce VaR or ES estimates that are too high.
Non-parametric approaches can have difficulty handling shifts that
take place during our sample period. For example, if there is a
permanent change in exchange rate risk, it will usually take time for
the HS VaR or ES estimates to reflect the new exchange rate risk.
Similarly, such approaches are sometimes slow to reflect major events,
such as the increases in risk associated with sudden market
turbulence.
If our data set incorporates extreme losses that are unlikely to recur,
these losses can dominate non-parametric risk estimates even though
we don’t expect them to recur.

Most (if not all) non-parametric methods are subject (to a greater or
lesser extent) to the phenomenon of ghost or shadow effects.
In general, non-parametric estimates of VaR or ES make no allowance
for plausible events that might occur, but did not actually occur, in
our sample period.
Non-parametric estimates of VaR and ES are to a greater or lesser
extent constrained by the largest loss in our historical data set. In the
simpler versions of HS, we cannot extrapolate from the largest
historical loss to anything larger that might conceivably occur in the
future. More sophisticated versions of HS can relax this constraint,
but even so, the fact remains that non-parametric estimates of VaR
or ES are still constrained by the largest loss in a way that parametric
estimates are not. This means that such methods are not well suited
to handling extremes, particularly with small- or medium-sized
samples.
ESTIMATING PARAMETRIC VaR: we therefore need to take account of

both the statistical distribution and the type of data to which it applies.
Estimating VaR with Normally Distributed Profits/Losses:
VaR(α) = −µ + σ ∗ zα
where zα is the standard normal variate corresponding to α.


Estimating VaR with Normally Distributed Arithmetic Returns
−Loss
rt =
Pt−1
VaR(α) = −(−µr + σr ∗ zα )Pt−1

Examples.


Estimating Lognormal VaR
Now assume that geometric returns are normally distributed with mean
µr and standard deviation σr .
VaR(α) = (1 − exp(µr − σr ∗ zα ))Pt−1

Examples.

ESTIMATING COHERENT RISK MEASURES

Estimating Expected Shortfall
The fact that the ES is a probability-weighted average of tail losses
suggests that we can estimate ES as an average of ’tail VaRs’.
The easiest way to implement this approach is to slice the tail into a
large number n of slices, each of which has the same probability mass,
estim ate the VaR associated with each slice, and take the ES as the
average of these VaRs.
Examples.

ESTIMATING COHERENT RISK MEASURES

Estimating Coherent Risk Measures
A coherent risk measure is a weighted average of the quantiles
(denoted by qp ) of our loss distribution:
Z 1
Mφ = φ(p)qp dp
0
where the weighting function or risk-aversion function φ(p) is specified

by the user.
The ES is a special case of Mφ :
0 if p < α

φ(p) = 1
if p ≥ α
1−α


THE CORE ISSUES: AN OVERVIEW

Which risk measure? The first and most important is to choose the
type of risk measure: do we want to estimate VaR, ES, etc.? This is
logically the first issue, because we need to know what we are trying
to estimate before we start thinking about how we are going to
estimate it.
Which level? The second issue is the level of analysis. Do we wish to
estimate our risk measure at the level of the portfolio as a whole or at
the level of the individual positions in it?

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Khoa Toán Kinh tế

Hoàng Đức Mạnh & Nguyễn Thị Liên

Khoa Toán Kinh tế

March 25, 2024

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 1

CHAPTER 5. MARKET RISK

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 2

Describe the mean-variance framework.

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 3

Estimate VaR using a historical simulation approach.

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 4

THE MEAN-VARIANCE FRAMEWORK

σP2 = w12 σ12 + w22 σ22 + 2ρw1 w2 σ1 σ2

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 5

THE MEAN-VARIANCE FRAMEWORK

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 6

VALUES AT RISK (VaR)

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 7

VALUES AT RISK (VaR): The VaR with a confidence level of X% is found

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 8

VALUES AT RISK (VaR): Limitations of VaR

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 9

EXPECTED SHORTFALL (ES)

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 10

COHERENT RISK MEASURE: A risk measure summarizes the entire

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 11

COHERENT RISK MEASURE:

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 12

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 13

Geometric Return Data: The geometric return rt is

The geometric return is often more economically meaningful than the

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 14

NON-PARAMETRIC APPROACHES: Historical Simulation

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 15

NON-PARAMETRIC APPROACHES: Historical Simulation

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 16

NON-PARAMETRIC APPROACHES: Historical Simulation

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 17

NON-PARAMETRIC APPROACHES: Historical Simulation-Estimating

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 18

NON-PARAMETRIC APPROACHES: Bootstrapped Historical Simulation

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 19

NON-PARAMETRIC APPROACHES: Bootstrapped Historical Simulation

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 20

NON-PARAMETRIC APPROACHES: Bootstrapped Historical Simulation

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 21

NON-PARAMETRIC APPROACHES: Bootstrapped Historical Simulation

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 22

NON-PARAMETRIC APPROACHES: Weighted HS Approaches

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 23

NON-PARAMETRIC APPROACHES: Weighted HS Approaches

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 24

NON-PARAMETRIC APPROACHES: Weighted HS Approaches

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 25

NON-PARAMETRIC APPROACHES: Monte Carlo simulations

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 26

NON-PARAMETRIC APPROACHES: ADVANTAGES OF

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 27

NON-PARAMETRIC APPROACHES: ADVANTAGES OF

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 28

NON-PARAMETRIC APPROACHES: ADVANTAGES OF

Hoàng Đức Mạnh & Nguyễn Thị Liên Risk analytics 29

NON-PARAMETRIC APPROACHES: ADVANTAGES OF