Calculating VaR

To calculate VaR, we first need to generate the forward distribution of the portfolio values at the
risk horizon or equivalently, the distribution of the changes in the value of the portfolio. From
this distribution, the mean and the quantiles are calculated.
There are three approaches to deriving this distribution:
1. The historical simulation approach.
2. The Monte Carlo simulation approach
3. The Parametric or Model -based approach

Parametric and Non-Parametric VaR

When VaR is derived from a distribution that is constructed using historical data, it is called
non-parametric VaR. If the VaR is derived assuming a particular theoretical distribution of the
returns, it is called parametric VaR. In this case, historical data are used to estimate the
parameters of the assumed distribution function. Non-parametric approaches can accommodate
skewness, fat tails and any other non-normal factors that can cause problems for parametric
approaches.

Historical Simulation Approach

The historical simulation approach to VaR is conceptually simple. First, the changes that have
been seen in the relevant market prices and rates (the risk factors) are analyzed over a specified
historical period, say, one to four years. The portfolio under examination is then revalued, using
changes in the risk factors derived from the historical data, to create the distribution of the
portfolio returns from which the VaR of the portfolio can be derived. Each daily simulated
change in the value of the portfolio is considered as an observation in the distribution. Three
steps are involved:

(i) Select a sample of actual daily risk factor changes over a given period of time, say 250 days
(i.e. one year’s worth of trading days).
(ii) Apply those daily changes to the current value of the risk factors and revalue the current
portfolio as many times as the number of days in the historical sample.
(iii) Construct the histogram of portfolio values and identify the VaR that isolates the first
percentile of the distribution in the left hand tail, assuming VaR is derived at the 99 percent
confidence level.
Example: Historical Simulation

Assume that the current portfolio is composed of 100,000 shares of stock of company and the
current price is Rs.26.30 per share The current value of the portfolio is Rs. 2.63 million. The
share price over the preceding 100 days is given in Table 1.

Table1: Historical Market Values for the Risk Factors over the Last 100 Days
--------------------------------------------------------------------------------------------------

Day Stock Price

(t) Rs.
-100 25.00
-99 25.20
-98 24.90
-97 24.80
--- ------
-3 26.75
-2 26.10
-1 26.25
0 26.30

Historical simulation requires re-pricing of the position using the historical distribution of the risk
factors. Table 2 shows the value of the stock assuming that the successive changes from now
onwards are the same as happened over the last 100 days. The change in stock price between day
-100 and day -99 is from Rs.25.00 to 25.20. If the current price changes by the same percentage,
it should be Rs.26.30 x 25.20/25.00= Rs.26.51 (rounded off to Rs.26.50). Proceeding in this
manner 100 alternate stock price scenarios are generated and changes in portfolio value from the
current value are calculated.

Table 2: Simulated Portfolio Values Using Historical Data

Scenario Alternate Price Change in Portfolio

Value (Rs. Million)

1 26.50 0.020
2 26.00 -0.030
3 26.20 -0.010
…. ….. ……
99 26.45 0.015
100 26.35 0.050
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The last step consists of constructing the histogram of the simulated portfolio returns or
equivalently sorting the changes in portfolio values over 100 days to identify the first percentile
of the distribution as shown in Table 3:

Table 3: Identifying the First Percentile of the Historical Distribution of the Portfolio
Return

Rank Change from Current Value

100 - 0.10
99 - 0.08
98 - 0.05
….. ……
2 + 0.07
1 + 0.08

Using the above Table, we identify the first percentile as 0.08. In the above example, the
estimate of VaR will be updated every day using the most recent 100 days of data

Weighted Historical Simulation

VaR based on historical simulation assigns equal weight to all the observations. The VaR so
calculated is not sufficiently responsive to the most recent information. Weighted HS assigns
relatively more weight to the most recent observation and relatively less weight to the
observations further in the past. The weights assigned to observations decline exponentially
through the past. The weight given to scenario i is:
 ni (1   )
1  n
λ is assumed to be a number between 0.95 and 0.99

Let the weights assigned to observations decline exponentially as we go back in time Rank
observations from worst to best Starting at worst observation sum weights until the required
quantile is reached

Example:

An example of weighted historical simulation using a λ value of 0.995 is given in Table 4

Table 4: Weighted Historical Simulation

Scenario Number Loss (Rs.000s) Weight Cumulative Weight

494 477.841 0.00528 0.00528
339 345.435 0.00243 0.00771
349 282.204 0.00255 0.01027
329 277.041 0.00231 0.01258
487 253.385 0.00510 0.01768
227 217.974 0.00139 0.01906
131 205.256 0.00086 0.01992

One-day 99% VaR is Rs.282,204 thousand

Volatility-Adjusted VaR

In the volatility updating scheme the percentage change observed on day i for a market variable
is adjusted for the differences between volatility on day i and current volatility.

The change in the value of the portfolio on day -100 is Rs.16 million. The stock return volatility
on that day is 1.11 percent. The current volatility is 2.19 percent. The simulated volatility
adjusted change on day -100 is 16 x0.0219/0.0111= Rs.31.57 million.

Historical Simulation: Advantages

The major attraction of historical simulation is that the method is completely nonparametric and
does not depend on any assumption about the distribution of risk factors.

We do not need to assume that the returns of the risk factors are normally distributed and
independent over time.

There is also no need to estimate volatilities and correlations as these are already reflected in the
data set.

Historical simulation has also no problem accommodating fat tails, since the historical returns
already reflect actual synchronous moves in the market across all risk factors.

Historical Simulation: Limitations

The main drawback of historical simulation is its complete dependence on a particular set of data
and thus on the idiosyncrasies of this data set.

The underlying assumption is that the past, as captured in the historical data set, is a reliable
representation of the future.

However, the historical period may cover events such as a market crash or conversely, a period
of exceptionally low price volatility, that are unlikely to be repeated in the future.
Similarly there may have been structural changes in the market such as the introduction of the
Euro at the beginning of 1999.

Another practical limitation of historical simulation is data availability. Employing small

samples of historical data leaves gaps in the distributions of the risk factors and tends to under
represent the occurrence of unlikely but extreme events.

Monte-Carlo Simulation
Monte Carlo simulation consists of repeatedly simulating the random processes that govern
market prices and rates. Each simulation (scenario) generates a possible value for the portfolio at
the target horizon (e.g. 10 days). If we generate enough of these scenarios, the simulated
distribution of the portfolio’s values will converge towards the true, although unknown,
distribution. The VaR can be easily inferred from the distribution.

Steps in Monte-Carlo Simulation

Monte Carlo simulation involves the following steps:

1. Choose a stochastic process and its parameters

2. Generate a sequence of random numbers from which prices are calculated
3. Calculate the value of the asset (or portfolio) under the particular sequence of prices at the
target horizon
4. Repeat steps 2 and 3 as many times as necessary (say10,000 times)

Stochastic Process

As a first step, we have to specify the stochastic process of the risk factor (e.g. stock price), and
estimate the parameters (volatilities, correlations, mean reversion factors for interest rate
processes and so on.) For example, a commonly used model for stock prices is the geometric
brownian motion. Small movements in stock price S can be described by:

dS /S = dt + dz
Where  is the expected rate of return per unit of time and  is the volatility of the stock price. dz
is known as a Weiner process and can be written as  dt where ε is a drawing from a standard
normal distribution

Price Paths

Price paths are constructed using random numbers produced by a random number generator.
Geometric Brownian motion provides the following equation that gives the price path for a stock
 St  St 1 (t   t )
Where t = time interval between t and t-1

To simulate the price path for S, we start from S and generate a sequence of epsilons (ε ) for
t i
i=1,2,…n. Then S is set as S = S + S (μ∆t+σε √∆t), S is similarly computed from S +S
t+1 t+1 t t 1 t+2 t+1 t+1
(μ∆t+σε √∆t) and so on for future values, until the target horizon is reached, at which point S
2 t+n
=S
T

Monte-Carlo Simulation: Example

The following example illustrates a simulation of a process with drift (μ) of zero and a volatility
(σ) of 10 percent over the total interval comprising 100 steps so that the volatility for each step
is 0.01(10/√100).

Step Previous Random Increment Current

Price (St-1) Variable (εt) (∆S) Price (St)

1 100.00 0.195 0.00199 100.20

2 100.20 1.665 0.01665 101.87
3 101.87 -0.445 -0.00446 101.42
4

100 92.47 1.153 -0.0153 91.06

From the distribution of prices at the target horizon, the VaR at the 99 percent confidence level is
simply derived as the distance to the mean of the first percentile of the distribution.

Monte-Carlo Simulation: Advantages

Monte Carlo is a powerful and flexible approach to VaR.

It can accommodate any distribution of risk factors to allow for ‘fait tail’ distributions, where
extreme events are expected to occur more commonly than in normal distributions, and ‘jumps’
or discontinuities in price processes.

It can also accommodate complex portfolios that contain exotic options (such as Asian options
and barrier options).

Monte-Carlo Simulation: Limitations

The major limitation of Monte Carlo simulation is the amount of computer resources it usually
requires. Some reduction techniques are available for reducing the computational time. Still,
Monte Carlo simulation remains very computer intensive and cannot be used to calculate the
VaRs of very large and complex portfolios. At most, it can be used for portfolios of a limited
size.