Extremes in nan

e and insuran e: An introdu tion

Erik Blviken
University of Oslo and the Norwegian Computing Center

May 18, 2001

Contents tted parameters ontaining errors? How

should the relevant quantities be omputed?
1 Introdu tion
2 Single variables Seen in this light extreme value methodology
3 Several variables
4 Dynami models
be omes a part of a broader spe trum of
5 The role of simulation
methods in statisti s and omputation and
6 Literature makes use of general ideas. To try to larify
Appendix Univariate distributions this issue onsider the upper quantiles1 of a
single random variable X , of whi h we have
Summary independent observations x1 ; : : :; xn . To
The note is intended as a preparation estimate the quantile we restri t the atten-
for a one-day ourse in extreme value
methodology. The emphasis is on introdu ing
tion to the largest observations. Spe ialized
on epts and ideas and posing problems by way methods have been designed to do just that.
of ases from several areas of insuran e and We shall dis uss some of them in the ourse.
nan e. Mathemati s will be used as sparingly
as possible. In property insuran e su h a situation
is ommon, but in nan e and e onomi s X
is often asso iated with a ertain time point
1 Introdu tion t, and there is a series of su h variables
Xt; Xt+1; : : :. Suppose we are interested in
This note summarizes some of the main the sum
topi s overed during a one-day ourse on
extremes, based on the following philoso- L = Xt+1 + : : : + Xt+h
phy. There are many thi k books dealing
with the mathemati s of extremes. For involving Xt up to h time units ahead.
example the mu h ited work of Embre hts, This happens, for example, when X is the
Kuppelberg and Mikosh (1997) dis usses pri e hange of some sto k on log-s ale.
(mostly) the extremes of single variables In pra ti e re ords of observations of su h
whereas Asmussen (2000) ta kles sto hasti hanges are available and an be used to
pro esses. However, other issues are for estimate the distribution of X , its extreme
the pra titioner at least as important and values in parti ular. But the distribution
also easier a essible for people la king a of L, its tail values in luded, requires the
heavy mathemati al ba kground, notably: distribution of X on the whole real line, not
How should the mathemati al models be just at its extremes, and the proper methods
onstru ted in pra ti e? What is the signi- to use ome from mainstream statisti s.
an e of the models being wrong and their 1
Denition in Se tion 2.2 below.

1
We shall in the ourse over the most Estimated density of Danish fire data
important problems of this type in nan e
and insuran e. The presentation will be an

0.8
integrated one where simple mathemati al
formulations, the use of histori al data
and omputation are brought together.

0.6
Examples ome from non-life insuran e
and nan ial time series from the sto k

0.4
and ele tri ity markets. The theoreti al
on epts presented will then be employed
in pra ti e and used to dis uss modeling
0.2
and quanti ation of real wold phenomena,
taking the view that most of what we an
a hieve by formal mathemati al methods
0.0

is to rely on the future to have the same 0 1 2 3 4 5 6

hara teristi s as those of the past.

Fire damage on log-scale

Figure 1: Estimated density (log-s ale) of

No attempt is made here to present all the damages (in million DKR) of Danish in-
that will be dis ussed in the ourse. The ob- dustrial res.
je tive is merely to introdu e some on epts,
ideas and also the examples. It is assumed
that the reader is familiar with the on ept
of a random variable X , its probability
density fun tion f , its distribution fun tion of the fund whi h starts at 200 million NKR.
F , its mean (or expe tation)  = E (X ) and
its varian e  2 =var(X ). Knowledge of the Re-insuran e, dealing with the right
normal distribution is also taken for granted. tail of the distribution is always a problem
Other quantities and on epts spe i ally of extremes. An example is how the pre-
onne ted to extreme value methodology mium should be al ulated. The s ar ity
will be introdu ed below. of data in Table 1 must then be a distin t
problem, and this is typi al for insuran e
and re-insuran e when rare, heavy damage
2 Single variables is involved. The issue will be dis ussed
during the ourse.
2.1 Examples
The se ond example has been used by
The study of extremes of single variables many a ademi s to exemplify new methods
will be illustrated by the data in Table 1 and for extremes. It omprises 2167 ases of
Figure 1. The former2 shows the pay-outs industrial res in Denmark during the
in the period from 1980 to 1999 from the period from 1980 to 1990. An estimate
Norwegian fund set up to over property of the probability density fun tion of the
damage in Norway due to storms and other log-transformed data have been plotted in
natural auses. The last three entries are Figure 1. The very heavy tail, even after
the ones that ae t the re-insuran e treaty passing to logarithms, is noteworthy. This
2
Made available through the ourtesy of hief example is suitable to illustrate many of the
a tuary Steinar Holm at Finansnringens Hove- elementary on epts of extremes of single
dorganisasjon in Oslo. variables.

2
 21.1 25.6 25.9 30.3 30.8 or in re-insuran e where u is the lower limit,
30.8 30.8 32.8 51.1 55.6 above whi h the re-insurer is obliged to
57.2 65.0 69.5 82.5 103.9 ome in.
119.3 174.1 175.6 514.8 855.0
1210.6 An alternative measure of extreme risk
is the mean ex ess fun tion. To dene this
Table 1: Damages (in million NKR) aused quantity we must invoke the on ept of
by natural disasters in Norway 1980 to 1999. onditional probability and onditional dis-
tribution. Introdu e again a xed threshold
2.2 Model quantities u and onsider the probability distribution
of X given that X ex eeds u. This is a per-
Simple measures of extremes will now be in- fe tly legitimate distribution and we denote
trodu ed. We shall deal with the right tail it by referring to the ondition X > u on
of the distribution, that is with large val- the left of a verti al bar. With this notation
ues3 . The most ommon des ription of the the mean ex ess fun tion be omes
risk of su h phenomena is in terms quantiles.
If X is a random variable, then the upper p- eu = E (X ujX > u); (3)
quantile, denoted xp , is the value for whi h
the probability is exa tly p that X will ex- signifying how mu h X on average is above
eed it, i.e. xp is the solution of the equation the threshold u if it is known to be larger.
Su h quantities go into the so- alled pure re-
P (X  xp) = p: (1) insuran e premiums and ould also be rele-
vant for the pri ing of ertain options.
Extreme value methodology deals with the
estimation and omputation of xp for small
values of p, say p = 0:05, 0:01 or even 0:001 2.3 Data quantities
and smaller. Quantiles are in statisti s often All three measures (1), (2) and (3) have
alled per entiles and are in nan e known simple empiri al ounterparts. Suppose
as Value-at-Risks (VaR). x1; : : :; xn are histori al observations of X .
If X is the damage of some type of industrial
An equally important on ept is that installation, then histori al re ords of earlier
of a threshold. We are then on erned with a idents would be available, or if X is the
the probability that X ex eeds a ertain monthly gain (or loss) of some sto k index,
given value u, i.e. in mathemati al terms we ould rely on experien e of the u tu-
pu = P (X  u): (2) ations of the index a ertain time ba k to
judge the likelihood of future extreme values.
This quantity an be regarded as the inverse
of (1), and the two of them an be derived For the quantile (1) we must rank the
from ea h other. If we know xp for all p, observations, say in des ending order
then we an also nd pu for all thresholds x(1)  x(2)  : : :  x(n) . Then x(pn) is the
u and the other way around, xp an be empiri al p-quantile (the analogy to xp ) and
found if all xu are known. The form pu is will be denoted
relevant to measure the risk of a nan ial
portfolio falling below some lower threshold4 x^p = x(np): (4)
3
All inequalities in (1), (2) and (3) below must For the other two measures we must intro-
be swit hed if the interest is in terms of the small du e nu as the number of observations larger
values of X . than the threshold u. Then
4
We must then swit h arguments to the other
tail, see footnote 3. p^u = nu =n; (5)

3
as the share of the observations ex eeding the density f (x) =  1 exp( x) for x > 05.
threshold, is the natural way to estimate pu . The result automati ally makes the Pareto
Moreover, the empiri al parallel to eu is model a andidate for extreme phenomena.
Sophisti ated te hniques based on this idea
e^u = (x(1) + : : : + x(nu ) )=nu u: (6) will be dis ussed during the ourse.
All three of x^p, p^u and e^u are statisti al esti-
mates of xp , pu and eu , and they are onsis- 2.5 The log-normal distribu-
tent in the sense that tion
x^p ! xp ; p^u ! pu ; e^u ! eu ; A number of other distributions suitable to
des ribe extreme phenomena is reviewed in
as the number of observations n ! 1. It an appendix, but due to its high importan e
may require prohibitively large values of n for in empiri al nan e it seems proper to dis-
these limits to materialize. However, when uss the log-normal distribution here. This
x^p , p^u or e^u are applied to simulations, these model is dened by its relationship to the
large values are pre isely what is en oun- normal; i.e. X is log-normal (;  ) if log(X )
tered; see Se tion 5 for an example where is normal (;  ). The expression for the prob-
the distribution of X is too ompli ated to ability density fun tion is
ompute and where xp is obtained from sim-
ulations. f (x) = f2 2g 1=2
x 1 expf Q(x)g;
where
2.4 The Pareto distribution Q(x) = (log x )2=(2 2):
More sophisti ated ways of estimating the The mean and the varian e are
measures of extreme values utilize the Pareto
distribution. The probability density fun - E (X ) = exp( +  2=2);
tion of this model is and
f (x) = ( 1 )=f1 + x=(r )g1+r ; x > 0: var(X ) = exp(2 +  2 )fexp( 2) 1g:
for positive parameters r and  . Expressions In nan e  is known as the drift and  as
for the mean and varian e are the volatility.

E (X ) = r=(r 1);
3 Several variables
r 3
var(X ) =  2 ;
(r 1)2(r 2) 3.1 Preliminaries
The on ept of joint distributions is a entral
whi h are nite only if r > 2 (r > 1 for the one in all areas of appli ations of sto has-
mean). ti modeling. In its simplest bivariate form6
The Pareto distribution has the rather 5
The exponential density an be regarded as
surprising property that it be omes the the limit of a Pareto model as r ! 1. The re-
only possibility for the ex ess over large
sult ited is proved in the book by Embre hts,
thresholds. Suppose X follows a general Mi kosh and Kuppelberg (1997). Stri tly speak-
ing there is third possibility in addition to the
density fun tion f and let fu be the on- Pareto and the exponential, but this third model
ditional density fun tion of X u given has properties that usually rules it out in pra -
that X > u. Then, as u ! 1, fu either ti e.
be omes a Pareto density or the exponential 6
The only one to be onsidered here.

4
 The most widely used bivariate model
TOTX against SP, lag=one day TOTX against SP, lag=one week is the normal one. There is then a spe i
expression for the probability density fun -
0.10

• •
•
•• • • •• •••••• •• ••••

0.1
•• • ••••••••••• • •••••••••••••••••••••
•
•••••••••••• •••••• •••••
•••••••••••••••••••••••••••••••••••••••••••
•••••••••••••••
••••••••••••••••••••••••••••
••••••••••••••••• ••••
•••• ••••••
•••••••
••••••••
••••••
••••••••••
••
•••••
•
••••••••
••••
••••••••••••••• •• •••
••••••••
••
•••••••••
•••
•••••••••••••••••• •
••
••
•••••••••••• • • ••
•••••
••••••
•••••••••
•••••• •••••••••••••
•••••
•••••
••••••••••••••••
•••••••
•••••••••••
tion7 , but that is of no on ern to us here.
0.0
•••••••••• •••
••••••••• ••••••••• ••••••••• •••••••••••
•••••••
It is mu h more onvenient to dene the
••••
0.0

••••••••••• •••••••••••••
•••••• ••
•• ••••••••••••••
••••••••••••• •• ••••••••••••••••••••••••••••••
•••••• ••••••• •••
••••••
•••••••
••••••••••••••••• ••••• ••••••••••••••••
•• •• ••••••••••••••••••
••••
••••
•••••••
•••
••••••••••••••• •••••••••••••••••••• •
•••• ••••••• ••••
••••••
•••••
••
••••• •••••••••• •••••••••••••••••••••• •• • •
• ••••••••••••••••••••••••••••• •••••••••••••••••
•••••••• ••••••
TOTX

TOTX
• • • • • •
•• ••• •••••••••••••••• • • • ••• ••••• ••• •••••••••••••• •
• •
-0.1
•
joint normal model sto hasti ally. Let "1
• • • • •• •
• •
-0.10

• • • • •• •• •
•
• • •
•• •
•
and "2 be two independent normal random
-0.20

-0.3

variables with means zero and standard

• •
-0.20 -0.10 0.0 0.05 0.10 -0.3 -0.2 -0.1 0.0 0.1
Standard and Poor Standard and Poor deviations 1. Then a pair of dependent,
TOTX against SP, lag=one day TOTX against SP, lag=one week normal random variable are dened through
0.2

0.2

X1 = 1 + 1"1 ;
0.1

0.1

••••••••••• •
•••••••••••••••• X2 = 2 + 2("1 + (1 2)1=2"2 );
-0.1 0.0

-0.1 0.0

•••••••••••••••••• • ••••••••
• •••••••
TOTX

TOTX

• •
•• ••••••••
• • ••

•
••
where i and i are the mean and standard
deviation for variable i and  is their orre-
•
-0.3

-0.3

-0.3 -0.2 -0.1 0.0 0.1 0.2 -0.3 -0.2 -0.1 0.0 0.1 lation. This type of denition is parti ularly
Standard and Poor Standard and Poor
suitable for our purpose, as it shows how
Figure 2: Upper row: S atter plots of daily dependent, normal random variables an be
and weekly relative growth (log-s ale )of simulated. It also immediately lear that the
TOTX against the Standard and Poor 500 normal model for pairs of random variable is
index. Lower row: Regression urves for a linear one, the relationships dening X1
the data in the upper row. and X2 being linear. The onstru tion of
normal models for an arbitrary number of
variables is similar, but needs matrix alge-
bra.
there are two random variables X1 and X2 ,
their distribution fun tion being dened by
3.2 An example
F2 ( 1 x ; x2) = P (X1  x2 ; X2  x2):
Correlation between dierent variables is of
Note that the probability that both variables high interest in e onomi and nan e. An
X1 and X2 are smaller than the limits x1 example is shown in Figure 2 where the daily
and x2 is spe ied. and weekly relative growth of the Standard
and Poor (SP) nan ial index and the total
Joint distribution fun tions will be de- index (TOTX) from the Sto k Ex hange of
noted by bold fa e (for example F2) to Oslo have been plotted against ea h other on
distinguish from the marginal probability log-s ale. Ea h dot relates to the same day
distributions F1 and F2 for the two random (or week) for the two indexes. The period in
variables individually. The latter an be question is from 1983 up to April 2000 and
obtained from the former sin e there are altogether 4240 points in ea h plot8
F2 (x1; x2) ! F1 (x1); as x2 ! 1;
F2 (x1; x2) ! F2 (x2); as x1 ! 1: It is not so easy to gauge the stru ture
This shows that the notion of joint sto has-
7
The joint distribution fun tion F2(x1 ; x2) is
ti models is a on ept ri her in ontents obtained from the probability density fun tion
f2 (x1 ; x2 ) by integrating the latter over the in-
than the models for the individual variables nite re tangle that runs up to x1 in one dire tion
added together. The degree of ovariation and x2 in the other.
of the two variables omes in addition in F2 . 8
Some days or weeks had to be ex luded due
to la k of data.

5
 eters were taken from the real data10. The
Normal, Lag=one day Normal, Lag=one week same number of points have been generated,
and exa tly the same statisti al methods
0.10
• •
0.4

•• ••• • • • •••• • • •• ••• •••• • •••• •• • •

• • • ••••••••••••••••••••••••••••••••••••••••••••••••• •••• •
•• • ••••••• •• •••• • •••• • • • ••• • •
• • ••• •••••••••••••••••••••••••••••••••••••••••••••••••••••••••• • • ••
have been applied to the simulations. The
0.0 0.05
• • • ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• ••••• • •
0.2

• • ••• •• ••••••••••• ••• • •

•• ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• ••••••••• ••• • • ••• •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
regression urves in the lower row now
• • •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• ••
•••••••••••••••• •
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Normal

Normal
•••••••••••••••••••••••••••••• •••••••••••••••••••••••••••••••••••••• •• •• ••••••••••••••••••••••••••••••••••••••••••• • •
••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• • •••
•• ••••••••••••••••••••••••••••••••••• ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• •
0.0

••• ••••••••••••••••••••••••••••••••••••••••
2

• •• • •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• • •• • • • •• ••••••••••••••••••••••••••••••••••••••••••••••••• •••••••••••••••••••••••••••••••••• • •
turn out to be linear, but no linearity was
• • • • • • • •• • • • • • • • • •
• • • • • • • • • • • • •
• • •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• •• • • • • • • • • •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• • • •
• • ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• • •• ••••••••••• ••••••••••••••• •••••••• • •
-0.2

• ••••••• ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• •• • • • • ••••••••••••••••••••••••••••••••••••••••••••••• •••••

• •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• ••
• • •• • ••••••••• •• ••••• ••••• •••
•• • ••••••• •• •• • • •• •
• • ••••• • •••• •••• imposed by the method. We may on lude
-0.10
-0.4

• • • • •• •

-0.4 -0.2 0.0 0.2 0.4 -0.10

•
-0.05 0.0 0.05 0.10 that other models are needed to deal with
Normal 1 Normal 1
the nan ial indexes at the lower tail. This
Normal, Lag=one day Normal, Lag=one week more advan ed subje t is dis ussed next.
0.10
0.4

Smoothed regression curve

0.05
0.2

Smoothed regression curve ••

•••• •
•••••••••
3.3 Latent variables
Normal 2

Normal 2

••• ••••• •• •••••••••••

•••••••••••••••••••••••••••• ••••••••••
••••••••••••••••••••••••••
0.0

0.0

••
•••
••
••••••••••••••••••••••••••••• •••
••••••••••
•
•
• • •••• ••••••• •••••••••
•••••••••
• •••
One of the simplest ways to extend the
-0.2

dependent normal model in 3.1 to ope with

-0.10
-0.4

-0.4 -0.2
Normal 1
0.0 0.2 0.4 -0.10 -0.05
Normal 1
0.0 0.05 0.10
empiri al phenomena su h as those in 3.2
is undoubtedly to introdu e the on ept
Figure 3: Upper row: S atter plots of sim- of a latent variable. A nan ial market
ulated daily and weekly relative growth a - may in a bear or bull ondition, but in
ording to the normal model. Lower row: reality one might envisage dierent degrees
Regression urves for the data in the upper of su h states. This view may be formulated
row. mathemati ally by introdu ing a latent
variable b, whi h we ould refer to as the
amount of bullness in the market, with,
say negative values for high bearness. Of
from the s atter plots in the upper row of
ourse, su h a variable is not observable
Figure 2. The lower row shows smoothed dire tly, but its presen e would be felt by
non-linear regression urves for the TOTX
the a tions of the parti ipants and by the
index against SP9 Noti e the steeper line pri e movements of the nan ial variables.
for the weekly data, whi h orresponds to
a higher orrelation than in the other ase. The model for X and X is now de-
Also note that the orrelation apparently 1 2
s ribed onditionally on b. One possibility
is higher at the lower extremes. This is
observation is important for the judging the
risk redu ing ee t of spreading investment. E (Xijb) = i + i b; i = 1; 2
If it is true that the orrelation tends to go var(Xijb) = i exp( i b); i = 1; 2 (7)
up as the sto k market is falling, the ee t orr(X1; X2jb) = =f1 + exp(b)g:
of diversi ation would be smaller.
Here 1 , 2 , 1 ,2 and  are additional pa-
Su h a phenomenon an not be explained rameters that allow volatility and orrelation
by normal models. Simulations from su h to depend on the market ondition. We shall
models are shown in Figure 3. The param- study the kind of behavior we an generate
with this tool during the ourse. As example,
9
These urves has been obtained by a so-
alled non-parametri te hnique, where the re- 10
For the daily data standard deviations were
gression line has been found by lo al straight lines 0:010 and 0:012 for SP and TOTX respe tively
tted in windows around ea h point on the hor- and the orrelation oeÆ ient 0:18. For the
izontal axis. The supsmu program of Splus was weekly ones the similar numbers were 0:02, 0:03
used. and 0:38.

6
suppose all of 1 , 2 , 1,2 and  are posi-
tive and that b varies around zero (say as a The SP and TOTX indexes from 1983 to 2000
standard normal random variable). Then a
small b diminishes the returns (rst line in

1400
(7)) and in reases volatility and orrelation
(se ond and third line).

1200
1000
3.4 Copulas

Index
800
TOTX
A more general, but less transparent way
of modeling dependen e is through opulas.

600
Suppose V1 and V2 are dependent random
400
variables so that ea h one is uniformly dis-
Standard and Poor

tributed over the interval (0; 1). Let C be

200

their joint distribution fun tion similar to F2

in 4.1. The fa t that we are dealing with uni- 1985 1990 1995 2000

form random variables means that C is only Years

dened on the quadrate with verti es at the Figure 4: The Standard and Poor and
origin and at (0; 1), (1; 0) and (1; 1). For C TOTX nan ial indexes from 1983 to 2000.
to be a valid distribution fun tion it must
satisfy the onditions
v ; 0) = 0;
C( 1 C(0; v2) = 0; is attra tive. We know how to model single
v ; 1) = v1;
C( 1 C(1; v2) = v2 : variables empiri ally. On e that has been
done mu h more ompli ated and subtle
The simplest su h fun tion would be types of dependen ies may on eivably be
C (v1; v2) = v1 v2 , whi h orresponds to des ribed mathemati ally by spe ifying the
independent random variables V1 and V2 , opula fun tion. One possibility ould be
but the point here is to allow dependen e.
C(v1; v2) = expfQ(v1; v2)g;

Su h a opula fun tion an be ombined where

with the marginal distribution fun tions
F1 and F2 of X1 and X2 to dene a joint Q(v1; v2) = f( log v1 )1= + ( log v2 )1= g ;
distribution of the form
and where 0 <   1 is a parameter. If
F2(x1 ; x2) = CfF1(x1 ); F2(x2 )g:  = 1, then C(v1; v2) = v1 v2, whi h yields
independen e between X1 and X2.
Not only is a fun tion F2 onstru ted like
this a valid distribution fun tion, but it
has also been established that that all joint 4 Dynami models
distribution fun tions F2 having F1 and F2
as marginals an be obtained in this way. 4.1 Preliminaries
The original SP and TOTX indexes, for
The opula on ept an be immedi- whi h the plots in Figure 2 were drawn, are
ately extended to an arbitrary number of displayed in Figure 4. Let St be the value
variables. Its potential has hardly been of one of the indexes on day t. The former
established. It will brie y be dis ussed analysis was then arried out in terms of
during the ourse. The omplete (and
remarkable) generality of the onstru tion Xt = log(St=St 1 ); (8)

7
 4.2 Sto hasti volatility
Estimated volatility
One of the issues that has been raised in
modern empiri al nan e is whether the
volatility  is onstant over time. This
0.04

Window length: Two months

has been he ked empiri ally in Figure 511.

Flu tuations in volatility is learly indi ated.
This suggests that the parameter  in (9)
0.03

might be repla ed by a time-dependent

Volatility

version t . We shall dis uss how this an be

arried out and what impa t it will have on
0.02

TOTX

extreme value evaluations during the ourse.

0.01

One approa h is through the bull-bear

Standard and Poor index introdu ed in 3.3, but now b will
be made time-dependent, i.e b = bt. Note
that this will permit both volatilities and
1985 1990 1995 2000
Years

orrelations to vary with time. We shall not

Figure 5: Running estimates of volatility be able during a one-day ourse to elaborate
(one-day data) for the Standard and Poor mu h on this.
and TOTX nan ial indexes

4.3 El-pri ing

or for weekly data on log(St=St 5 ). The Extremes are also of interest in onne tion
time t has been introdu ed spe i ally in with the modern, deregulated ele tri ity
the notation sin e we are now on erned market. The Nordpool index from 1995
with dynami aspe ts. to 2001 is plotted on log-s ale in Figure 6
(upper left orner). Su h series are known
The standard model for nan ial time to ontain ee ts due to weekday (lowest
series is the random walk in terms of pri es in the weekends) and limati ee ts
Lt = log(St), i.e. due to the season of the year (highest in
winter). These have been subtra ted out
Lt = Lt 1 +  + "t ; (9) in the series on the lower right, whi h we
shall use to illustrate the same ideas as the
where "1; "2 ; : : : are independent random nan ial indexes in 4.2.
variables with mean zero and standard de-
viation one. We are dealing with a Gaussian The weekday impa t was estimated as
random walk if they are Gaussian. The pa- the average of all pri es (log-s ale) on that
rameters  and  in (9) are the drift and day and has been shown on the upper right
volatility. Note that Xt in (8) an be written of Figure 6. The seasonal ee t (lower left)
11
The volatility estimates were onstru ted by
Xt =  + "t: dening a window of length w around ea h day t
and omputing
With several time series running in parallel ^t = fx2t w + : : : + x2t+w )=(2w + 1)g1=2:
we have to supply one model for ea h series
and allow the error terms "t to be orrelated This rude estimate of the volatility at t has been
between series. used in Figure 5 with w being one month.

8
 instead of the real data, yielding omputer
Elprice on log-scale Elprice: Weekday effect approximations of the tail quantities xp,
pu and eu . They an be made arbitrary
Daily elprice (log-scale)

a urate by making m large enough; see the

4.95
6

Week day effect

4.90
losing remark in 2.3.
5

4.85
4

A simple example from portfolio man-

4.80

Monday Sunday

agement illustrates the idea. Suppose the

3

1995 1996 1997 1998 1999 2000 2001 1 2 3 4 5 6 7

Years Week days
portfolio onsists of a risk-free deposit in
Elprice: Climatic effect Elprice: Residual series a bank, earning a xed monthly interest of
0:5% and investments of shares in four risky
1.5
0.1 0.2

sto k indexes that develop a ording to a

Residual elprice
Climate effect

0.5

Gaussian random walk on log-s ale with

-0.1

drift parameter  = 0:005 and standard

-0.5

deviation  = 0:05 for ea h index ea h

-1.5
-0.3

January December
0 100 200 300 1995 1996 1997 1998 1999 2000 2001
month; see Se tion 4 above. On average
ea h index is up
Day number Years

Figure 6: The Nordpool ele tri ity index

exp(0:005 + 0:052=2) = 1:0063;
from 1995 to 2001, the original data (log-
s ale (upper left), the residual series (lower from one month to another; see 2.5. It is
right). assumed that all the sto k indexes u tuate
independently of ea h other. The weights
of the four investments are 0:4 for the
was obtained by passing a lter of length bond and 0:15 for the four others, with no
two months over the series12 re-balan ing taking pla e.

The value of the portfolio is in mathe-

5 The role of simulation mati al terms
X = w1A + w2S1 + w3 S2 + w4S3 + w5S4 ;
5.1 A simple example
where w1; : : :; w5 are the ve weights and A
The ourse will present several examples and S1 ; : : :S4 are the urrent value of the
where the distribution of X , although not savings a ount and the sto k investments.
depending on any unknown quantities, The fa t that the latter are log-normally dis-
is in pra ti e impossible to ompute by tributed presents a te hni al problem, sin e
traditional mathemati s. Frequently X sums of variables that are log-normally dis-
an be sampled or simulated instead, and tributed have omplex, almost intra table
estimates of quantiles and other quantities distributions. Simulation easily over omes
of the distribution omputed from the simu- the obsta le. Very a urate approximations
lations. Suppose x1 ; : : :; xm are obtained by of the 5% value-at-risk based on one million
drawing X in the omputer13 Then (4), (5) simulations are re orded in Table 2 ( olumn
and (6) an be applied to the simulations 2) for various fore asting times.
More pre isely, the estimate for day t of the
12

year is the average of two months of pri es around 5.2 The general idea
t, one month on either side.
13
All variables that are omputer simulations The prin iple involved in the pre eding ex-
are marked with a  . ample is that of a me hanism M produ ing

9
 ^k obtained from histori al data, and the
Predi tion True Data history dis repan ies ^k k and ^k k are the
time ahead estim 2 years 10 years only sour es of errors in the Value-at-Risk
VaR SD SD evaluations.
One month 0.982 0.003 0.002
One year 0.988 0.034 0.017 The ee t of this an be studied through
Five years 1.191 0.235 0.102 nested simulation s hemes. The situation is
as shown:
Table 2: 5% value-at-risk for nan ial port-
folio as des ribed in the text, true value and D ! M^ ! m
X
ee t (standard error) due to estimation er- "
ror Histori al data M
On the upper row real histori al data D are

an output X (= X when emphasizing the used to determine the estimated model M^ ,
simulation) or s hemati ally from whi h m simulations are drawn for the
Value-at-Risk approximations. The estima-
M ! X (M = real world): tion pro ess leading to M^ an also be simu-
lated. We then use the drift parameters and
Although the mathemati al treatment of volatilities ^ and ^ we already have, to gen-
k k
this relationship was ompli ated, it ould erate simulated histori al data D and from
be run in the omputer, so that approxima- D reestimate M^ , now alled M^  . Finally
tions to the distribution of X were obtained,
Value-at-Risk is omputed from M^  . The
its tails in luded. situation has now be ome:
There is a problem with this pro edure D ! M^  ! m
X
that has nothing to do with omputations. "
Ideally M should have been the nan ial Simulated data M^
system itself, but the working of this system Unlike in the real ase we have now a ess
is enormously omplex and a urate des rip-
to as many repli ations of the simulated
tion beyond rea h. All we an get hold is histori al data D as we please. This means
a rude approximation M^ and generate the that the estimated models M^  vary among
simulations a ording to themselves. It is pre isely the ee t of this
M ! X
^  (in pra ti e M 6= M ): variation on the Value-at-Risk assessments
^
we want to examine.
What are the impli ations of the fa t
that M 6= M^ ? Clearly it means that our Sometimes su h a study reveals that
Value-at-Risk assessments dier from those an estimate systemati ally overestimate or
that would have been obtained under the underestimate the quantity under study.
real model. It is never possible to analyze Su h was not the ase in the present exam-
su h issues ompletely, but one aspe t an ple, and only the estimated standard error
be ta kled. has been re orded in Table 2 ( olumns 3
and 4). Note the ee t of the length of the
Suppose the Gaussian random walk period of histori al data. 10000 simulations
model used to des ribe the u tuations were used for the Value-at-Risk evaluations
of the sto k, was stri tly true, ex ept for and 100 repli ations of the histori al data
unknown drift and volatility, say k and k were generated, in both ases suÆ iently
for the k'th nan ial variable. The model high numbers to limit the ee t of Monte
M^ would then orrespond to estimates ^k Carlo randomness.

10
6 Literature tail.

The most widely ited referen e on extremes

is A Univariate distribu-
Embre hts, P., Kuppelberg, C. and Mikosh, tions
T. (1997). Modeling extremal events.
Springer. A.1 Introdu tion

The reader will there nd the mathe- All parametri distributions have unknown pa-
mati s of extremes, mostly for single rameters that must be found from histori al data
variables. A referen e dealing with extremes x1; : : :; xn. An alternative is to use the so- alled
for sto hasti pro esses is empiri al distribution

Asmussen, S. (2000). Ruin probabili- P (X = xi) = 1=n; i = 1; : : :; n;

ties. World S ienti Press.
whi h is not based on any mathemati al assump-
I know of no books that treat statisti- tion on the shape of the density. The rest of this
al methodology for extremal events the se tion is a brief summary of the most important
way I have tried to do here. The losest one is probability distributions apturing extreme phe-
nomena, adding to those in Se tion2. The normal
distribution is then in pra ti e ruled out sin e its
Beirlant, J, Teugels, J.L. and Wyn ker, tails are not heavy enough.
P. (1996). Pra ti al analysis of extreme
values. Leuven University Press,
A.2 Gamma
but the situations whi h that work has
in mind is mu h more restri tive than The gamma distribution has density
what I have envisaged. There is a growing
literature on opulas. A simple presentation (r= )r r 1
f (x) = r exp( rz= );
an be found in (r )

M neil, A.J. (1999). Extreme value for r > 0 and where r and  are positive param-
theory for risk managers. Departement eters . The mean and varian e are
14

Mathematik, ETH Zentrum, Zuri h.

E (X ) = ; var(X ) =  2 =r;
The enormous literature on models based
on latent variables, the dynami ver- and this yields an immediate interpretation of the
sion in parti ular, has, as yet, not exploded two parameters (and, in identally, explains why
in empiri al nan e. A re ent ontribution is we have hosen to redene the parameters om-
pared to those usually found in the literature).
Ball, C.A. and Torus, W.N. (2000). The gamma model is losed under onvolution.
Sto hasti orrelation a ross international Suppose X1 and X2 are independently gamma
distributed with parameters (r1; 1 ), and (r2; 2 )
sto k markets. J Empiri al Finan e, 7, respe tively and suppose  =r =  =r . Then
1 1 2 2
373-388. the sum X1 + X2 is also gamma distributed, but
now with parameters 1 + 2 and r1 + r2 .
Finally, the April issue (2001) of Jour-
nal of Finan e ontains an arti le by Longin 14
The fun tion (r) is the so- alled gamma
and Solnik dealing with orrelations at the fun tion.

11
A.3 Shifting the distribu- where
p
tions f0 (x) =  1 p
exp( 2 p  2 + x)
Both the Pareto, the log-normal and the gamma K1 ( 1 + x2 )= 1 + x2;
distributions started at the origin. It is possible and where K is the so- alled Bessel fun tion of
to shift su h a distribution to an arbitrary initial the rst kind,1 i.e.
point a by dening
Z1 p
Xa = X + a: K 1 (x ) = x exp( xt) 1 t2 dt:
1

The new random variable Xa has the same dis- Among the four parameters , ,  and  the
tribution as the old one X , ex ept that it an former two represent lo ation and s ale, like the
not fall below a. Sometimes this parameter a is similar ones for the normal, whereas the remain-
added as a third parameter. ing two, whi h must satisfy  > 0 and j j < ,
aptures many dierent shapes, for example the
normal as  ! 1, heavy-tailed distributions as
A.4 The t-distribution  ! 0 and skewed ones as  is raised from 0 in
The t-distribution extends over the whole real either dire tion. The mean and varian e are
line. Its density is =
E (X ) =  +  ;
f (x) = ( r =)(1 + r (x=) )
1 2 (r +1)=2
f1 (=)2 g1=2
 1
var(X) = 2
where r is a onstant dened by the ompli ated f1 (=)2 g3=2
expression
It is of little importan e that the expression for
((r + 1)=2) the density is a horrible mathemati al expres-
r = p :
r (r=2) sion. What does matter are the properties of the
model, and that it an be sampled omparatively
Mean and varian e is easy.
Suppose X1 and X2 are independently NIG-
E (X ) = 0 distributed with parameters 1 , 1, 1, 1 and
2, 2, 2, 2 . If 1=1 = 2=2, then the sum
and X1 + X2 is also NIG distributed, now with pa-
rameters 1 + 2, 1 + 2 , 1 + 2 and 1 + 2 .
var(X ) = r=(r 2) This is a useful property when using the model to
des ribe u tuations in share pri es on log-s ale.
where the latter requires r > 2 to be valid. The Another point of interest is tail behavior, whi h
t-model equals the normal in the limit as r ! 1. is lose to, but not entirely equal to, the de ay of
an ordinary exponential distribution.
A.5 Normal inverse Gaussian
The normal, inverse, Gaussian (NIG) family of
distributions runs, like the ordinary normal and
the t-distribution, over the whole axis. The
model is able to portray many dierent types of
shapes, but still, remarkably, possesses the on-
volution property, i.e. that sums of independent
NIG variables remain NIG distributed. This does
not apply in full generality. It is true when the
NIG variables have identi al distribution.
The probability density fun tion is the om-
pli ated expression
f (x) =  1f0 f(x )=g

12