Simulation of Risk

Measures
VaR – Value at risk
• First ingredient for estimating risk measures is the estimation of a quantile

• The value-at-risk of level 𝛼 (𝑉𝑎𝑅𝛼 ) is the 𝛼 -quantile of the loss of the financial position 𝑋
(at time 𝑇)
𝑉𝑎𝑅𝛼 (𝑋) ∶= 𝑞𝛼 = 𝐹 −1 (𝛼) = inf{ 𝑥 |𝐹(𝑥) ≥ 𝛼}

where 𝛼 is a high percentage such as 95% or 99%

➢ If 𝐹 is explicitly known, calculate by numerically solving 𝐹(𝑥) = 𝛼

➢ Otherwise (when 𝐹 is not available or hard to compute) use Monte Carlo method

• Natural Monte Carlo estimator for an 𝛼 -quantile 𝑞𝛼 = 𝐹 −1 (𝛼) of a random variable 𝑋 with
distribution function 𝐹 is obtained by generating 𝑁 realizations of 𝑋 and then using the 𝛼 –
quantile 𝑞ො𝛼,𝑛 of the empirical distribution 𝐹𝑛 (𝑥)
Crude Monte Carlo simulation of the 𝛼
-quantile
• Let 𝐹 be a given d.f., 𝛼 ∈ 0, 1

Algorithm Crude Monte Carlo simulation of the 𝛼-quantile

1. Simulate 𝑛 independent random numbers 𝑋1 , … , 𝑋𝑛 ~ 𝐹 and sort them: 𝑋1:𝑛 ≥ · · · ≥ 𝑋𝑛:𝑛
1
2. Compute the empirical distribution function 𝐹𝑛 (𝑥) = σ𝑛𝑖=1 1𝑋𝑖≤𝑥
𝑛

3. Estimate 𝑞ො𝛼,𝑛 = 𝐹𝑛−1 𝛼 = 𝑋 𝑛 1−𝛼 +1:𝑛

• By ordering the simulated values in step 1, the inversion of the empirical distribution
function is done in a simple way
Expected shortfall
• Let 𝐹 be the continuous distribution function of 𝑋 and 𝛼 ∈ [0, 1]
• The expected shortfall at level 𝛼
1
1
𝐸𝑆𝛼 (𝑋) ∶= 𝐸(𝑋|𝑋 > 𝑉𝑎𝑅𝛼 𝑋 ) = න 𝑉𝑎𝑅𝑝 𝑋 𝑑𝑝
1−𝛼 𝛼
• Discrete distribution: several definitions

Algorithm Crude Monte Carlo simulation of 𝐸𝑆𝛼 (𝑋)

1. Simulate 𝑛 independent random numbers 𝑋1 , … , 𝑋𝑛 ~ 𝐹 and sort them: 𝑋1:𝑛 ≥ · · · ≥ 𝑋𝑛:𝑛
෢ 𝛼,𝑛 = σ 𝑛 1−𝛼
2. Estimate 𝐸𝑆
+1
𝑋𝑖:𝑛 ൗ 𝑛 1 − 𝛼 +1
𝑖=1