Nour de Vos, Major assignement 42728711

Part A 1) We calculate the Var 5% assuming continuously compounded returns with normal distribution and mean, standard deviation equal to their sample values for the first 500 returns, we find by excel mean of 0.09, SD = 1.0890 and thus by excel (NORMINV(0.05,0.09,1.0890)), we find for normal distribution a VAR 5% = -1.69856215. For the ES with normal distribution, we use the formula O^-1(5%) , which is represented in excel by NORM.S.INV(0.05) and we compute O(NORM.S.INV(0.05)=0.10313564, and finaly we compute our Expected Shortfall by this dividing the last result by 0.05, which give us : 0.10313564/0.05=2.062712808. Thus, ES normal distribution = 2.06271. By historical distribution: we compute the Var 5% in excel by using SMALL(500firstdata,25) we use 25, because 25 represent 5% of 500, and we find Var 5% = -1.7519, which is clearly different from the first var with normal distribution. The difference make clear that the historical distribution is not strictly normal. For the historical Expected shortfall, we have computed the average of the smaller 50 values, which in excel is computed by =Average(SMALL(range,1,2,3,50). We find an historical expected shortfall = 1.94527. Here, the ES is different, but the difference remain light. 2) In this part we use the 250 last return. a) We find the number of var exceedances in excel by the function Countif(range,<VarNorDist5%), here we used the normal distributed Var 5% above, and we found 5 exceedances. We have also computed the Violation ratio which is N/p*W where N= number of exceedances, p=5% and W=250. We find a VR Normal distributed = 5/(0.05*250)=0.4. With the same process, we find the number of exceedances for the historical distribution using historical var, and we find 3 exceedances with a violation ration of 3/(0.05*250)=0.24. Thus, there is a significant difference between the exceedence in normal distributed return, and with the set of historical data, which confirm the non-normal distribution of the historical data. EXPECTED EXCEEDENCES

b) we now compute the average loss, by making the average of exceedances, which is an average of the 5 exceedences for the case of the normal distribution, we find an average loss of -2.4236. for the Historical average loss, we compute this time the 3 exceedances and we find a Average loss of -2.903454.

3) By computing the Var in a normal distribution and by computing the var with the historical set of data, we found a significant difference between this 2 var. (Var 5% in normaly distribution = 1.6985, instead of -1.751929 for the var 5% with the historical distribution). This difference is very important in our analysis, because it tell us that the historical distribution of our stock is not strictly normal. The second step to know more about our distribution, is to analyse our distribution more closely, by looking at the summary statistic in excel : 4) Mean 5) 0.092834 6) Standard 7) 0.048706 Error 8) Median 9) 0.03767 10) Mode 11) #N/A 12) Standard 13) 1.089092 Deviation 14) Sample 15) 1.186121 Variance 16) Kurtosis 17) 3.463294 18) Skewness 19) -0.39376 20) Range 21) 11.05636 22) Minimum 23) -5.519 24) Maximum 25) 5.537363 26) Sum 27) 46.41702 28) Count 29) 500 And as expected, we find that our distribution is not strictly normal (already induced by the difference in our var) by a mean which is different than 0. But this statistics also showed to us that our distribution have a positive kurtosis (3.4634) and is skewed negatively (-0.39376). Now, we have computed the ES for both of the distribution, and we find a difference, but which remain light (ES NS = 2.06 against ES Hst=1.9452). The second part of our analysis showed that we found a different number of exceedances, with 5 exceedances for Normal distribution against only 3 exceedances for the Historical Distribution. In our case, this difference is clearly significant, and represent an important point, because of our criteria, which can be limited to 5exceedances/year for example.() Finally, we have computed the average loss on the exceedances, and we have found another significant difference, which continue to affirm our thesis of a non-normal distribution for our historical set of data, which an average loss of -2.4236 for the normal distribution against a loss of -2.9034 for our historical distribution. This difference is not in our favor, because the special distribution of our stock show that the average loss is more risky in our stock than for a normal distribution. This argue for an effective hedge strategy, which we are going to see in part B.

Part B 4) a) Estimate the Minimum Variance Hedge : we know h* = Cov (F,B)/Var(F) where F = hedge instrument return and B our initial set of daily return, we thus find : Cov(F,B) on excel which = 0.474332147, and we thus divided this covariance by the var(f) and we find h*= (0.474332147/1.04099588) = 0.45565

b) Thus for knowing the effectiveness of our hedge, we need to compare the variance between the unhedged portfolio and the hedged portfolio. For the first 500 daily return, we find a hedged variance by this formula : Variance hedged = Var (C-hF)= Var( C) + h*^2(varF)-2hcov(C,F), we find an hedged Variance =0.453587. Second we calculate the effectiveness for our hedge by comparing the hedged variance to the unhedged variance, we find R2=0.453587/1.18612=0.38241, which is not positive for our hedge, because this hedge is expected to only eliminate 38% of the cash variance. We can also explain this low effectiveness by the low covariance between our first return, and our hedged instrument return, the covariance is only 0.4743.

5. a) We find a total return of 1.37, which represent an increase of+37% for our naked portfolio, without any hedge, and we find a total return for 1.20 for the hedged instrument, which give a total return of LN(1170000/1370000)= -0.15780 for our hedged portfolio return. Thus hedged return underperform by more than 15% the naked position.

For computing the variance of hedged we use this formula : Variance hedged = Var (C-hF)= Var( C) + h*^2(varF)-2hcov(C,F). thus Variance hedged = 0.81822+0.45565^2*0.526231-2*0.45565*0.34244= 0.6153 Thus, Ratio variance hedged/variance unhedged =0.61539/0.81822=0.75 b) If we consider a position if $1m position, we have the choice between a possible return of 1.37 which represent 1.370 000 but with a high variance of 0.8182 and with a high volatility of 0.9045. And a second choice With our hedged portfolio, with an expected return of 1212193 (, which still represent a gain of 21.21% but with a lower variance because of the hedge. (variance hedged of 0.615 instead of 0.8182)

6. In our quantitative analysis above, we have showed that, first the hedge ratio of minimum variance is 0.4557, but most importantly we have found that as if our hedge is reducing the variance, the effectiveness of our hedge represented by R2=0.3841 is not effective enough to be fully implemented. This lack of effectiveness is partially due to a low covariance between our return and the hedge instrument. We cant expect to have a high effectiveness hedging if our hedging instrument have a low covariance with our main stock return. In addition, this minimum variance hedge is costly, and need us to understand that, by implementing this hedge, we are giving up some upside, for more confidence and more certainty by less variance. In this case, the difference between naked position and hedged position is about 20%, with a 37% return with high volatility (0.90) and variance (0.8182), and 17% with low hedged variance of 0.6115. This is also confirmed by the ratio of hedged variance/unhedged variance which is equal to 0.752. Finally, depending on our overall strategy, I recommend to implement the hedge as if we give up some upside, because of the benefit of a low cash variance but still with a remaining considerable and more certain gain.