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VaR - Model Based Approach
VaR - Model Based Approach
Delta-Normal VaR
Suppose there is a single underlying which has a
mean return of x= (S/S), where the price of the
underlying is S, volatility is and the instrument
has a delta with respect to the underlying, then
the change in the value of the instrument is
P= S or Sx.
The volatility of the instrument is P=S
Delta-Normal VaR
When there are more than one underlyings, the ith
underlying has a mean return of xi (Si/Si), where Si is
the price of the underlying. volatility of i and the asset has
a delta i with respect to the ith underlying, then the
change in the portfolio value has a mean of
n
P i Si xi
i 1
2P i j Si S j i j i , j
i 1 j 1
Delta-Normal Approximation
Advantages
Computational Attractiveness: Portfolios with several
thousand positions spread across hundreds of underlyings can
be handled very fast.
Modest data requirement: Only volatilities of underlyings
and pair-wise correlations required.
An organization called Risk Metrics provides daily estimates
of volatilities and correlations for hundreds of stock indices,
exchange rates, interest rates, commodity prices to facilitate
use of these methods
Delta-Normal Approximation
If the portfolio has only cash, forward or futures
positions in the various underlyings, then the
formulas for mean and variance of the portfolio
values are exact.
If the portfolio has option positions, then these
formulas are approximate as they ignore the effect
of gamma, vega and other greeks.
Cash-Flow Mapping
It involves choosing as underlyings the prices of zerocoupon bonds with standard maturities: 1 month, 3
months, 6 months, 1 year, 2 years, 5 years, 7 years, 10
years and 30 years.
For the purposes of calculating VaR, the cash flows from
instruments in the portfolio are mapped into cash flows
occurring on the standard maturity dates.
Suppose that zero rates, daily bond price volatilities and
correlations between bond returns are as shown in the
following Table.
Cash-Flow Mapping
Maturity
3-month
6-month
1-year
bond
bond
bond
--------------------------------------------------------------------------------------Zero rate
(% with ann. Comp.)
5.50
6.00
7.00
Bond price volatility
(% per day)
0.06
0.10
0.20
---------------------------------------------------------------------------------------Correlation between
Daily returns
3-month bond
1.0
0.9
0.6
6-month bond
0.9
1.0
0.7
1-year bond
0.6
0.7
1.0
Cash-Flow Mapping
Consider a Rs. 1 million position in a Treasury bond lasting 0.8 years
that pays a coupon of 10% semi-annually.
A coupon is paid in 0.3 years and 0.8 years and the principal is paid in
0.8 years.
The bond is regarded as Rs.50,000 position in a 0.3 year zero-coupon
bond plus a Rs. 1,050,000 position in a 0.8 year zero-coupon bond.
The position in the 0.3 year bond is replaced by an equivalent position
in 3-month and 6-month zero coupon bonds and the position in the 0.8
year bond is replaced by an equivalent position in 6-month and 1-year
zero coupon bonds.
Thus, the position in the 0.8 year coupon bond is for VaR purposes
regarded as a position in zero-coupon bonds having maturities of 3
months, 6 months and 1 year.
Cash-Flow Mapping
For the cash flow of Rs.1,050,000 to be received in 0.8
years, the zero rate is interpolated as 6.6% and the
volatility as 0.16%
The present value of Rs.1,050,000 to be received in 0.8
years is:
1, 050, 000
Rs.997, 662
0.8
1.066
Suppose we allocate of the present value to the 6-month
bond and (1-) of the present value to the 1-year bond.
We can find the value of by equating the variances:
Cash-Flow Mapping
The value of is calculated as 0.320337.
This means that 32.0337% of the value should be allocated to a
6-month zero-coupon bond and 67.9663% should be allocated
to a 1-year zero-coupon bond.
The 0.8 year bond worth Rs.997,662 is therefore replaced by a
six- month bond worth Rs.319,589 (0.320337*Rs.997662) and
by a 1-year bond worth Rs. 678,074 (0.679663*Rs.997,662).
The present value of Rs.49,189 of Rs,50,000 at time 0.3 years
can , similarly, be mapped to a position worth Rs.37,397 in a 3month bond and a position worth Rs.11,793 in a 6-month bond.
Cash-Flow Mapping
The summary of the cash flow mapping is given below:
-----------------------------------------------------------------------------Rs.50,000 Rs.1,050,000 Total
received in
received in
0.3 years
0.8 years
--------------------------------------------------------------------------------Position in 3-month bond
37,397
37,397
Position in 6-month bond
11,793
319,589
331,382
Position in 1- bond
678,074
678,074
Cash-Flow Mapping
The variance of the position based on the respective
volatilities and correlations is Rs.2,628,518 and the
standard deviation is Rs.1621.3.
The 10-day 99% VaR is:
Principal Components-Example
The following principal components are linear
combinations of swap rates of different maturities . These
are derived using historical data.
PC 1
PC2
PC3
1-year
0.216
-0.501
0.627
2-year
0.331
-0.429
0.129
3-year
0.372
-0.267
-0.157
4-year
0.392
-0.110
-0.256
5-year
0.404
0.019
-0.355
7-year
0.394
0.194
-0.195
10-year
0.376
0.371
0.068
30-year
0.305
0.554
0.575
Factor Loadings
The coefficients of factors in a principal component are called factor
loadings.
These are the correlations between the original variables and the factors.
The components have the property that the factor scores (the sensitivity
of a position to a component) are uncorrelated across the data.
For example, the first factor score (amount of parallel shift) is
uncorrelated with the second factor score( amount of twist) across all days
4-year rate
5-year rate
7-year rate
10-year rate
+10
+4
-8
-7
+2
Factor Sensitivities
These sensitivities have to be converted into
sensitivities to each principal component.
Factor Sensitivities
The factor score of PC1 (delta exposure to PC 1) in millions of
dollars per unit of the component is:
10 x 0.372 +4 x 0.392 + (-8) x 0.404 +(-7)x 0.394 +2 x 0.376
=- 0.05
The factor score of PC 2 in millions of dollars per unit of the
component is:
10 x (-)0.267 +4 x (-)0.110 + (-8) x 0.019 +(-7)x 0.194 +2 x
0.371 = - 3.87
Value at Risk
Denoting PC1 by f1 and PC2 by f2, the change in portfolio value is
approximately
P =-0.05 f1-3.87 f2
The standard deviations of factor scores for PC1, PC2 are 17.55
and 4.77, respectively and the factor scores are uncorrelated
The standard deviation of P is:
Handling Options
When a portfolio includes options, the delta-normal model is
an approximation. It does not take into account the gamma
of the portfolio.
A long call option has a positive gamma and a short call
option has a negative gamma.
The probability distribution of the call option price has a
positive skew in case of a positive gamma and a negative
skew in case of negative gamma, when the probability
distribution of the price of the underlying asset is normal.
Assumption of a normal distribution for the call option price
would lead to either a high or low calculation of VaR.
Delta-Gamma Approach
For a more accurate estimate of VaR than that given by the
delta-normal model, a quadratic model (delta-gamma
approach) is used that takes into account the delta and
gamma of the option position.
Consider a portfolio dependent on a single asset whose
price is S. Suppose and are the delta and gamma of the
portfolio and return is x = S/S
S
(x22
S
)2x2
Delta-Gamma Approach
Delta-Gamma Approach
When x is assumed to be normal, the Moments are
E (P ) 0.5S 2 2
E (P 2 ) S 2 2 2 0.75S 4 2 4
E (P 3 ) 4.5S 4 2 4 1.875S 6 3 6
Delta-Gamma Approach
From the moments of the probability distribution of P, the
following quantiles can be calculated
P E (P)
2
2
E P E (P )
2
P
3
2
3
3
E
P
P
3
P 1/ P E P P
P3
P i Si xi
i 1
i 1 j 1
1
i , j Si S j xi x j
2
P
Si S j
1
P i S i xi i , j S i S j xi x j
i 1
i 1 j 1 2