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P - VaR(P)
s
i
p
i
p
2
i
( p
[ p.6]
1
500
p
i
)
1
500
s
i
. (5)
and the scenario-type estimator based on equation (1),
s
[ p.6]
. (6)
Of course, we can use standard statistical techniques such as the maximum-
likelihood method (see Kay 1993) to generate other parametric estimators if we
are willing to make use of the a priori knowledge that the random variables are
Gaussian. However, for this exercise we wish to take a very general approach.
Step 3: Analyse the results Finally, we calculated the standard error of the 2000
estimates given by equations (5) and (6). This procedure was repeated using
correlations 0, .05, .10, .15, . . . , 1. Figure 1 plots the standard error of the two
estimators against the correlation of p and s. It is clear that the two estimators
exhibit markedly dierent behavior. The following observations are evident.
+ Performance of the scenario-type estimator improves signicantly as correlation
increases.
We will provide some intuition for this behavior by rigorously examining the
endpoints. When P provides no information about S, the correlation is 0 and
s
[ p.6]
is simply a random sample of S. In this case, we expect s
[ p.6]
to have the
same variance as S itself. This explains why the standard error in Figure 1 is very
nearly 1 when , = 0. On the other hand, when P provides complete information
on S, the correlation is 1 and s
[ p.6]
= s
[ s.6]
. Since this is an estimator of VaR(S),
we know from elementary sampling theory (see Lehmann 1998) that this
estimator is approximated by a normal distribution whose variance decays in
proportion to 1,N. For a normal distribution at 99% condence, the propor-
tionality constant is 13.94. This leads us to expect the simulation experiment to
exhibit a standard error of approximately
_
(13.94
1
500
) = 0.17, which is very
close to the realized standard error of 0.13. With this explanation of the two
extreme cases, it is natural to expect a standard error somewhere between these
extremes when P provides partial information about S. This is exactly what
Figure 1 demonstrates.
Journal of Risk
R. B. Carroll et al. 62
+ Performance of the parametric estimator has a parabolic shape; as correlations
increase it initially improves, but eventually deteriorates.
Equation (5) can be interpreted as a regression evaluated at an estimate of
VaR(P). Thus we can think of the error as arising from both the regression
equation and from the point at which the regression equation is evaluated.
Regression theory (see Weisberg 1985) tells us that the standard error of a
regression decreases as correlations increase. Thus, when the correlation is very
high, error from the regression equation is very low. However, the coecient of
VaR(P) will be large and so equation (5) will be sensitive to errors in the
estimate of VaR(P). When correlation is very low, the regression will be a poor
t, but it will not be sensitive to errors in VaR(P). The performance observed in
Figure 2 shows the interplay between these conicting error sources. The
optimal correlation is approximately 0.225.
+ The parametric estimator has substantially less variance than the scenario
estimator, especially when the correlation is low.
Since the performance of the parametric estimator is far superior, we expect
similar behavior even when the distributions are only approximately Gaussian.
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0
0.2
0.4
0.6
0.8
1
1.2
FIGURE 1. Standard error vs. correlation for scenario (top) and parametric (bottom)
estimators. For every given correlation, 2000 samples were generated containing
500 elements each.
Volume 3/Number 3, Spring 2001
A new approach to component VaR 63
5. SUMMARY
The following paragraphs summarize the fourfold contribution of this paper.
5.0.1 Denition of CVaR. The new denition in equation (1) provides an
elegant framework for practical and theoretical analysis of component VaR.
5.0.2 Analysis of CVaR. Section 3 expresses CVaR in terms of familiar statistics.
In particular, Theorem 1 is a convenient expression of CVaR that makes very
general assumptions about the underlying distributions.
5.0.3 Estimators for CVaR. We used equation (1) to derive the familiar
scenario-type CVaR estimator that can be used with historical or Monte Carlo
VaR methodologies. We also explained how to use the equations from Section 3
to devise new estimators, which we referred to as ``parametric estimators'', that
can be used with any risk management methodology.
5.0.4 Practical implementation. Among the two approaches for CVaR estima-
tion applicable to scenario-based VaR implementations, the simulation in
Section 4 provides a strong argument for using a parametric estimator for
approximately normal P&L distributions. We also provided an explanation for
the observed behavior of the estimators.
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0.09
0.095
0.1
0.105
0.11
0.115
0.12
0.125
0.13
0.135
0.14
FIGURE 2. Standard error for the parametric estimator. For every given correlation,
2000 samples were generated containing 500 elements each.
Journal of Risk
R. B. Carroll et al. 64
APPENDIX
The following theorem shows that the denition of component VaR above is
consistent with the JP Morgan denition of incrmental VaR (see Laubsch 1999).
This result is stated, but not proved, by Hallerbach (1999).
Theorem 2 Let s be the market value of portfolio o and let D be the P&L of a
$1 investment in portfolio o, so that S = sD. If both CVaR(S) and (o,os)VaR(P)
exist, then
CVaR(S) = s
o
os
VaR(P). (7)
It is tempting to approach this result by calculating
s
o
os
VaR(P) = s
o
os
{sE[D [ P = VaR(P)] E[P S [ P = VaR(P)]]
= sE[D [ P = VaR(P)]
= E[S [ P = VaR(P)]
= CVaR(S).
Unfortunately, this approach overlooks the subtlety that the expectation terms
are functions of s since they are conditioned on a function of s. Hence the
derivative may not be so simple. Instead, we will approach the theorem from its
foundations. It is rst necessary to dene precisely what we mean by expectation
conditioned on a point. Denote the probability measure by j. If
lim
c0
1
j(T
c
)
T
c
Xdj = C
for every sequence of sets satisfying j(T
c
) > 0 and lim
c0
T
c
= Y
1
(y), then we
dene E[X [ Y = y] = C. Otherwise, we say that E[X [ Y = y] does not exist.
Proof. Dene three families of sets as follows:
U
c
= {P 6 VaR(P) and P cD > VaR(P cD)].
V
c
= {P > VaR(P) and P cD 6 VaR(P cD)].
W
c
= {P 6 VaR(P) and P cD 6 VaR(P cD)].
From the denition of value-at-risk, we know that
j
P 6 VaR(P)
= j
P cD 6 VaR(P cD)
.
It is evident from the decompositions
j
P 6 VaR(P)
= j(U
c
) j(W
c
)
and
j
P cD 6 VaR(P cD)
= j(V
c
) j(W
c
)
Volume 3/Number 3, Spring 2001
A new approach to component VaR 65
that j(U
c
) = j(V
c
). Suppose that there exists an c
0
such that j(U
c
) = 0 for every
c - c
0
. Dene the sets T
o
= {VaR(P) o 6 P 6 VaR(P)] and observe that
the denition of U
c
gives
D 6
VaR(P) P
c
VaR(P cD) VaR(P)
c
onT
o
. (8)
for all c - c
0
. Integrate equation (8) over T
o
and divide by j(T
o
) to obtain
1
j(T
o
)
T
o
Ddj 6
1
c
1
j(T
o
)
T
o
[VaR(P) P] dj
VaR(P cD) VaR(P)
c
.
Take limits to see that
E[D [ P = VaR(P)] 6
o
os
VaR(P).
Apply an analogous argument using V
c
to show that
E[D [ P = VaR(P)] >
o
os
VaR(P).
Thus we have shown that the theorem holds for this case. Otherwise, assume
without loss of generality that j(U
c
) > 0 for c - c
0
. (If this does not hold, then
we can nd a subsequence for which it does.) Note from the denition of U
c
that
VaR(P cD) VaR(P)
c
6 D on U
c
. (9)
Integrate equation (9) over U
c
and divide by j(U
c
) to see that
VaR(P cD) VaR(P)
c
6
1
j(U
c
)
U
c
Ddj on U
c
.
Take limits to see that
o
os
VaR(P) 6 E[D [ P = VaR(P)].
Just as with the case above, apply an analogous argument using V
c
to show that
o
os
VaR(P) > E[D [ P = VaR(P)]. &
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Journal of Risk
R. B. Carroll et al. 66
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Volume 3/Number 3, Spring 2001
A new approach to component VaR 67