Value-at-risk
Knowing your limits
Value-at-risk limits are widely used risk management instruments. But issues over
the allocation of Var limits remain, says Brett Humphreys
alue-at-risk1 (Var) limits have
V become commonplace risk
management tools for energy
companies in the past five years. These
limits are used to control the amount of
risk taken by a business unit.
However, as Var limits have become
more widely used, risk managers have
been forced to deal with a number of
related issues. Two of the most common
questions are: how does one allocate Var
limits between members of a corporate
group, and what should be done if Var
limits are exceeded?
Allocating Var
Allocating Var limits is often one of the
first tests of the Var limit system. The
problem here is that Var limits are not
cumulative consider the following
simple equation for calculating the
portfolio Var from the Var of two
component portfolios (Vara and Varb):
Var _ portfolio =
Vara2 + Varb2 + 2Vara Varb
where is the correlation of changes in
values between the two component
portfolios.
The portfolio Var will be the sum of
the two component Vars only if the
correlation equals one. If the correlation
is less then one, the portfolio Var will be
less than the sum of the individual Vars.
This is the problem we face if we wish to
allocate Var between members of a group.
In such a situation, we know the total
portfolio Var limit and want to know the
appropriate component limits. Assuming
we want to equally allocate the limit
between the two business units, the only
additional information we need is the
correlation between each sub-group. We
can then use that correlation and the total
limit in the above equation to derive the
appropriate component limits.
For example, consider a trading desk
that has a Var limit of $10 million and is
made up of two desks: North America
1 Var is the worst loss expected to be suffered over
a given time period with a given probability
and Europe. If for some reason we know
that the portfolios held by the two desks
have a 50% correlation, then the best
equal division of the limit would be $5.8
million assigned to each desk, calculated
from the equation above. The table on
page 62 shows the optimal breakdown
based on the correlation of positions
held by the two desks.
It is clear that as the correlation
between the two desks decreases, we can
raise the Var limit of each individual desk
without violating the total Var limit of
$10 million. This method of allocating
Var limits works well as long as the two
desks actively use their Var limits and the
correlation used for allocation is correct.
However, imagine a case where we
believe the correlation between the two
desks to be 75%, and so allocate a
$14.14 million limit to each desk. It may
occur where one desk actually has no
exposure but the other desk has risk up to
its limit of $14.14 million. The total risk
in this case would be $14.14 million,
Two of the most common questions relating to Var limits are:
how does one allocate them between members of a corporate
group, and what should be done if they are exceeded?
higher than the expected $10 million. The
actual total risk is higher because we had
assumed that the second desk would have
positions with risk close to their Var limit,
which are needed to offset the risk of the
first desk.
This problem highlights a weakness of
this allocation method: we can never
know with certainty what the correlation
between two trading books will be,
especially when we do not know the exact
trading instruments or positions that the
desk is using.
To further highlight this difficulty,
consider a simple situation of a natural
gas trading desk. For one month, the desk
may take positions based on the belief
that natural gas prices will be rising so
the net desk position will be long.
However, in the next month the trading
desk may change its overall view to the
belief that natural gas prices are falling
and shift its overall position to short.
If overall positions can change
significantly, allocating static Var limits
based on correlations will tend to mis-
allocate the limits. If we create good Var
limits then it should never be possible for
every sub-group to be under their limit
while the total Var is greater than the
limit. However, the only way to be certain
such a situation cannot occur is to assume
perfect correlation between groups and
split the total Var limit between the
groups. While this method avoids the
summation problem it does so by
allowing no diversification benefits.
So far we have only discussed an
equal allocation of Var limits between
groups, but it is easy to modify this
allocation in whatever manner we choose.
For example, we could allocate limits
based on the profits each group made the
previous year. So if the first group had
profits of $10 million and a second group
had profits of $5 million we would
allocate a Var limit of two-thirds the total
Var limit to the first group and one-third
to the second group.
Breaking the limit
Of course, after all the effort has been
made to set the appropriate Var limits,
some group will eventually have a Var
greater than the allocated limit. What
should be done in this situation?
At some companies, the traders may
be directed to immediately enter into
trades that reduce the Var of the position.
At others, the risk manager might review
the positions and grant a temporary
www.eprm.com I 61
Value-at-risk
increase of the Var limits. What is the
correct solution?
Forcing the traders to immediately
enter trades to reduce the Var seems a
harsh solution. For instance, sometimes
markets shift and simply become more
volatile. In such cases, perhaps it is more
important to raise limits.
Another potential problem with this
policy is external manipulation.
While this may be easier to do in
illiquid markets, large traders with
sufficient funds can move any market. To
avoid such activity, we need a rule that
does not automatically force the
liquidation of positions.
Reviewing the limits seems a practical
solution. However, the problem with this
solution is that the limit tends to be raised
if the group has been profitable in the
past or if overall market risk increased
and not based upon the underlying merits
of the position.
One method that may avoid these
problems is to allow traders to purchase
the additional Var limit. This allows the
person who can best evaluate the merits of
the trade the trader to decide whether
62 I March 2002
trades are only marginally profitable then
Table 1: Optimal Var breakdown they are not worth the risk associated
with them and should be liquidated.
Correlation between desks Var limit per desk We can take this a step further. We
75% $14.14 know that by allocating Var limits based
50% $10.00 on the assumption of perfect correlation
we are not likely to use the entire Var limit
25% $8.16 as there will be some diversification. The
0% $7.07 risk management group could, therefore,
25% $6.32 sell this diversification back to the groups
in the form of increased Var limits. If
50% $5.77
demand is higher than available Var, this
75% $5.35 sale could take the form of an auction to
100% $5.00 ensure the most efficient allocation.
The method proposed would improve
the efficiency of allocating Var limits
to maintain it or reduce the risk of the and handling Var exceptions. By shifting
position. The price of the additional risk to a market solution for Var allocation,
should be a risk charge or risk-adjusted we shift from a hard rule that may be
return on capital (Raroc) for the desk. biased to allowing those that know the
For example, if the best-performing positions to decide whether to keep or
trading group has returns of 30% on risk reduce them. EPRM
capital, any trader may be allowed to
increase his or her Var limit by paying Brett Humphreys is a founding
this 30% premium from past profits. partner of Risk Capital
Under this approach, if the trader really Management, a risk management
believes in the trades he or she will advisory group based in New York
happily pay the additional cost, but if the e-mail: hbrett@e-rcm.com