Financial Risk Management

Assignment No.1

Calculation of VaR

Introduction
Value at risk (VaR) is a statistical technique used to measure and
quantify the level of financial risk within a firm or
investment portfolio over a specific time frame. This metric is
most commonly used by investment and commercial banks to
determine the extent and occurrence ratio of potential losses in
their institutional portfolios. VaR calculations can be applied to
specific positions or portfolios as a whole or to measure firm-wide
risk exposure.
VaR modeling determines the potential for loss in the entity being
assessed, as well as the probability of occurrence for the defined
loss. VaR is measured by assessing the amount of potential loss,
the probability of occurrence for the amount of loss and the time
frame. For example, a financial firm may determine an asset has
a 3% one-month VaR of 2%, representing a 3% chance of the
asset declining in value by 2% during the one-month time frame.
The conversion of the 3% chance of occurrence to a daily ratio
places the odds of a 2% loss at one day per month.

Methods of calculating VaR :

There are three methods of calculating VAR: the historical method, the variance-covariance
method and the Monte Carlo simulation.

1.Historical Method:
The historical method simply re-organizes actual historical
returns, putting them in order from worst to best. It then assumes
that history will repeat itself, from a risk perspective.

2. The Variance-Covariance Method:

This method assumes that stock returns are normally distributed.

In other words, it requires that we estimate only two factors an expected (or average) return and a standard deviation - which
allow us to plot a normal distribution curve.

3.Monte-Carlo Simulation:
The third method involves developing a model for future stock
price returns and running multiple hypothetical trials through the
model. A Monte Carlo simulation refers to any method that
randomly generates trials, but by itself does not tell us anything
about the underlying methodology.

Confidence Level and Holding

Period
The choice of probability/confidence level and holding period
would depend on the purpose of estimating the VaR measure. It is
now a common practice, as also prescribed by the regulators, to
compute VaR for probability level 0.01, i.e. 99% confidence level.
A useful guideline for deciding holding period, is the liquidation
period the time required to liquidate a portfolio 2. An alternative
view is that the holding period would represent the period over
which the portfolio remains relatively stable. Holding period may
also relates to the time required to hedge the risk. Notably, a rise
in holding period will increase the VaR number. One may also get
same outcome by reducing probability level (i.e. increasing
confidence level) adequately (instead of changing holding period).
In practice, regulators maintain uniformity in fixing probability
level at p=0.01 (equivalently, 99% confidence level). Thus,
holding period has to be decided based on some of the
consideration stated above. It may be noted that VaR for market
risk may have much shorter holding period as compared to say

VaR for credit risk. Basel Accords suggests 10- day holding period
for market risk, though country regulators may prescribe higher
holding period. In case of credit risk, duration of holding period is
generally one-year.

Risk of the portfolio

VaR itself is a risk measure. Given probability level p
and holding period, larger VaR number would indicate
greater risk in a portfolio. Thus, VaR has ability to rank
portfolios in order of risk. The second, it gives a numerical
maximal loss (probabilistic) for a portfolio. Unlike other
common risk measures, this is an additional advantage in
measuring risk through VaR concept. Third, VaR number
is useful to determine the regulatory required capital for
banks exposure to risk.
Apart from the general usages of VaR concept, it is also
worthwhile to note a few points on its applicability to
various risk categories. Though there has been criticism
against it as being not a coherent risk measure and
lacking some desirable properties, it is a widely accepted
risk measure today. Though VaR was originally endorsed
as a tool to measure market risk, it provides a unified
framework to deal with other risks, such as, credit risk,

operation risk. The essence of VaR is that it is a percentile

of loss/return distribution for a portfolio. So long as we
have data to approximate/fit the loss distribution, VaR
being a characteristic of such distribution, can be
estimated from the fitted distribution.
Given Portfolio ( Equal Weightage of each stock i.e. 20% )
:
1. Airtel
2. Mahindra
3. Bajaj Auto
4. Axis Bank
5. ACC

Regulatory Requirements
The concept of VaR was first introduced in the regulatory domain
in 1996 (BIS, 1996) in the context of measuring market risk.
However, post-1996 literature has given ample demonstration
that the same concept is also applicable to much wider class of
risk categories, including credit and operational risks. Today, VaR
is considered as a unified risk measure and a new benchmark for
risk management. Interestingly, not only the regulators and banks
but many private sector groups also have widely endorsed
statistical based risk management systems, such as, VaR.

The implementation of Basel III norms commenced in India from

April 1, 2013 in a phased manner, with full compliance initially
targeted to be achieved by March 31, 2018 but extended to March
31, 2019. The Reserve Bank of India specified minimum Tier 1
leverage ratio of 4.5 percent during the parallel run period as
against the Basel Committees minimum Tier 1 leverage ratio of 3
percent. This leverage ratio has been revised based on the recent
proposals of the Basel Committee. Again, as the biggest concern
for the financial sector and the real sector is associated with the
growing volume of the restructured assets and non-performing
assets, a framework for revitalizing distressed assets has been
implemented in the economy which has come into effect from
April 2014. The guidelines of the framework include early
recognition of financial distress, information sharing among
lenders and co-ordinated steps for prompt resolution and fair
recovery for lenders. It focuses on the formation of lenders
forums and incentives for lenders and borrowers for the
improvement of the current restructuring process such as
mandating 28 independent evaluation of large value restructuring
which emphasizes on the viability and fair sharing of gains and
losses between creditors and promoters. The CCCB should
increase from 0 to 2.5 percent depending upon the banks risk
weighted assets (RWA) on the position of the gap between the
points of 3 percent and 15 percent. The Indian banking system
faces the challenge of complying with the stringent requirements
of Basel III framework, while at the same time maintaining growth
and profitability. The RBI prescribes a minimum Capital to Risk
Weighted Asset Ratio (CRAR) at 9 percent, higher than 8 percent
prescription of Basel III accord.

Backtesting
As recommended by Basel Committee, central banks do not
specify any VaR model to the banks. Rather under the advanced

internal model approach, banks are allowed to adopt their own

VaR model. As known, VaR is being used for determining
minimum required capital larger the value of VaR, larger is the
capital charge. Since larger capital charge may affect profitability
adversely, banks have an incentive to adopt a model that
produces lower VaR estimate. In order to eliminate such inherent
inertia of banks, Basel Committee has set out certain
requirements on VaR models used by banks to ensure their
reliability (Basel Committee, 1996a,b) as follows ;
(i) 1-day and 10-day VaRs must be estimated based on the daily
data
of
at
least
oneyear
(ii) Capital charge is equal to three times the 60-day moving
average of 1% 10-day VaRs, or 1% 10-day VaR on the current day,
which ever is higher. The multiplying factor (here 3) is known as
capital
multiplier.
Further, Basel Committee (1996b) provides following Backtesting
criteria for an internal VaR model (see van den Goorbergh and
Vlaar, 1999; Wong et al., 2003, among others)
(i) One-day VaRs are compared with actual one-day trading
outcomes.
(ii) One-day VaRs are required to be correct on 99% of backtesting
days. There should be at least 250 days (around one year) for
backtesting.
(iii) A VaR model fails in Backtesting when it provides 5% or more
incorrect VaRs.
If a bank provides a VaR model that fails in backtesting, it will
have its capital multiplier adjusted upward, thus increasing the
amount of capital charges. For carrying out the Backtesting of a

VaR model, realized day-to-day returns of the portfolio are

compared to the VaR of the portfolio. The number of days, when
actual portfolio loss is higher than VaR estimate, provides an idea
about the accuracy of the VaR model. For a good 99% VaR model,
this number would approximately be equal to the 1 per cent (i.e.
100 times of VaR probability) of backtesting days. If the number
of VaR violations or failures (i.e. number of days when observed
loss exceeds VaR estimate) is too high, a penalty is imposed by
raising the multiplying factor (which is at least 3), resulting in an
extra capital charge.

Descriptive Statistics
Portfolio
Mean
Standard Error
Median
Mode
Standard Deviation
Sample Variance
Kurtosis
Skewness
Range
Minimum
Maximum
Sum
Count

4.16983E-05
0.000409054
0.000173599
#N/A
0.014392673
0.000207149
236.8759104
10.17697588
0.381056756
-0.045965873
0.335090883
0.05162251
1238

Methods used of calculating VaR

of the portfolio :
Method-1
Var-Covar Method or Parametric
Method
Data :

Daily closing price of the given stocks is taken from BSE

India website for five years (2011-16)

Return Series :

For each given stock, we consider the

continuously compounded daily returns computed as follows ;
Rt = ln ( Pt / Pt-1)
Where Pt and Rt denote the price and return in t-th day.
Portfolio Return Series :
Using the weighted average formula of calculating portfolio return
using individual stock data, we will get the return series of
portfolio which can be shown on the histogram :

Histogram

Frequency

600
500
400
300
200
100
0

Frequency

Bin

Standard Deviation of the portfolio:

It can be easily found from the following formula :

Using this formula, the standard deviation series can be found

out.
Now, one-day VaR can be calculated as:

Capital Requirements :
Margin or Capital Requirement = Maximum of VaR(t-1) ,
Avg.VaR(60 Days) * 3.33