Financial Derivatives and

Financial Engineering Weeks 12 & 13

Value at Risk
 Learning Outcomes

By completion of this topic you will be able to:

• Explain why a single measure of risky positions will be useful
to institutions and regulators
• Understand how VaR provides such a measure
• Appreciate the role of volatility and correlation in computing
VaR
• Compute VaR for single and multiple asset portfolios
• Understand the limitations of VaR and importance of stress
testing and back testing
A Concise Risk Measure
 Financial Institution Portfolio

Senior Management
Team

Equity Debt Derivatives Currencies

Options Futures Forwards Swaps

Financial Risk Measures
 Basel Accord Capital
Adequacy Requirement (2004)
What is VaR?
e more than £v in the next n days’
Typical VaR Statement

ply by √n to give the n-day VaR

Choosing the Distribution
Historical Simulation
Construct the Distribution
Estimating the VaR
The VaR Statement
 Expected Shortfall

• Average the observations in the left tail of the

distribution
• These are the worst possible outcomes at a given
confidence level
• The average of these losses gives the expected
shortfall estimate
 Evaluating the Approach

• Historical data are used to determine probability

distributions
• Avoids cash flow mapping
• Criticised for being computationally slow
• Cannot easily incorporate volatility updating
methods
 Value at Risk

The Model Building or

Variance-Covariance
Approach
 The Model-Building Approach
(or Variance-Covariance Approach)
• Relies crucially on estimates of volatility of assets and
correlation between assets
• Illuminates the benefits of diversification
• Involves making assumptions about the probability
distributions of returns on assets in portfolio
• Provides an analytical solution
• Assuming 252 trading days per year:
 Example 1:
Calculating the VaR of a single variable:
 Example 1 (continued)
Estimated daily change in market variable = 0
From tables of the cumulative normal distribution:
N(-2.33) = 0.01 [more precisely N(-2.32635)]
This means we are 99% certain a normally distributed
variable will not decrease in value by more than 2.33
standard deviations
1 day 99% VaR = 2.33 x 200,000 = $466,000
10 day 99% VaR = 466,000 x √10 = $1,473,621
We are 99% certain we will not lose more than
$1,473,621 in the next 10 days
Example 2: the 2 asset case
Example 2 (continued)
Example 3: Calculating the VaR of
precious metals
Example 3 (continued)
Adding another asset
 Example 3 (continued)

σg+s

= 10,200

N(-1.96) = 0.025
Example 3 (continued)
Example 4
Example 4 (continued)
Example 4 (continued)
Example 4 (continued)
Linear Model
 Cash Flow Mapping
• Bond coupons and maturity payments are expressed in terms
of zero-coupon bonds
• Select prices of zero-coupon bonds with standard maturities
as market variables
• Map cash flows from fixed income securities held onto cash
flows occurring on standard maturity dates
• For example, a coupon due in 8 months can be expressed in
terms of a combination of a 6-month and 1-year zero-coupon
bond
• Linear model now contains stocks and zero-coupon bonds
with standard maturities
 Portfolios with Options (linear model)

• Delta measures the change in option value with respect to

underlying stock
• Change in the value of an option portfolio is given by

Where:
ΔP = change in value of option portfolio
S = value of market variable (stock price)
δ = delta
Δx = percentage change in stock price in 1 day
 Example (adapted from Hull (2018))

Delta of option portfolio:

M = 1,000 A = 20,000
Underlying asset price:
M = $120 A = $30
Daily volatility:
M = 2% A = 1%
ρMA = 0.3
ΔP = 120,000Δx1 + 600,000Δx2
120,000 x 0.02 = 2,400, 600,000 x 0.01 = 6,000*

= 7,099
*assumes equivalence to investment in M and A
 Quadratic Model
• Linear model is an approximation for portfolios containing
options
• Delta is non-linear and rate of change is measured by gamma
• Therefore probability distribution of portfolio can be
negatively or positively skewed according to the value of
gamma
• Hence greater accuracy can be achieved using a quadratic
model
• The quadratic model is beyond the scope of this module
Discussion
Stress Testing
Back-Testing
Criticisms of VaR
Criticisms of VaR
Conclusion
 Further Reading

• Some important sources on VaR

– Hull, J.C. (2015), Risk Management and Financial
Institutions, 4th edition, Wiley.
– Jorion, P. (2000), ‘Risk management lessons from
Long-Term Capital Management’ European
Financial Management.