Value at Risk

How much do you stand to lose, over a certain period and with a
certain probability?
Assume that:
Everything assumed in the (VaR) calculations/process is true
All approximations made are accurate
The future follows the past and whatever risk you are analyzing only exists
for the specified (certain) period
Its efficacy depends on how the tool is put to use.
Is the one number sufficient by itself to completely capture the risk in a position?
Whether the users of VaR understand the limitations (of the tool) and the implications of
those limitations?

Risk management is concerned with extreme events or large deviations from what is
expected. The most common tool used for measuring the above is variance, an average (of
sorts) of all the deviations from the mean. Although it is the key tool used in calculating
VaR, it is not the most appropriate. Higher order factors that measure symmetry or length
& thickness of tails would be more accurate.

VaR uses data from all events to evaluate the impact of extreme events. VaR is forced to do
this because by definition, extreme events do not occur frequently enough to generate
sufficient data. The downside is that extreme events have much higher means and
variances. This means that if VaR (somehow) did use extreme events, it would lead to a
much higher Value at Risk estimate.

Given that the object of risk management is to understand risk exposures and neutralize
them, there is a strong emphasis on supplementing VAR with scenario analysis or
sensitivity testing.
Value at Risk (VAR) is a market risk measurement approach that uses
historical market trends and volatilities to estimate the likelihood that a
given portfolios losses will exceed a certain amount.
VAR measures the largest loss likely to be suffered on a portfolio or a position
over a holding period (usually 1 to 10 days) with a given probability
(confidence level).
Assuming a 99% confidence level, a VAR of 1 million US dollars means that
the there is only a one percent chance that losses will exceed the 1 million
US dollar figure over the next ten days. It is also fashionable to refer to this
loss as the one day in 100 days loss.
There are three primary methods used for calculating Value at Risk (VAR).
a. Variance /Covariance method
b. Historical simulation method
c. Monte Carlo simulation method
All methods have a common base but then diverge in how they actually calculate
Value at Risk (VAR). They also have a common problem in assuming that the future
will follow the past. This shortcoming is normally addressed by supplementing any
VAR figures with appropriate sensitivity analysis and/or stress testing.
VAR calculation follows five steps:
Identification of positions for Value at Risk
Identification of risk factors affecting valuation of positions.
Assignment of probabilities (or statistical distribution) to possible risk factors
values.
Creation of pricing functions for positions as a function of values of risk factors.
Calculation of Value at Risk (VAR)
Variance Covariance Approach
This method assumes that the daily returns follow a normal distribution. From the
distribution of daily returns we estimate the standard deviation .
The daily Value at Risk VaR is simply a function of the standard deviation and the
desired confidence level.
In the Variance-Covariance VaR method the underlying volatility may be calculated
either using a simple moving average (SMA) or an exponentially weighted moving
average (EWMA).
This approach is generally utilized if it is believed that the daily returns during
the look back period have followed normal market conditions.

The SMA approach places equal importance to all returns in the series whereas
the EWMA approach places greater emphasis on returns of more recent
durations.
The method gets its name from the variance-covariance matrix of securities
that is used to calculate Value at Risk (VaR).
The method starts by calculating the standard deviation and correlation for the risk
factor and then uses these values to calculate the standard deviations and correlation
for the changes in the value of the individual securities that form the position.
If price, variance and correlation data is available for individual securities then this
information is used directly.
The values are then used to calculate the standard deviation of the portfolio.
Value at Risk (VaR) for a specific confidence interval is then calculated by multiplying the
standard deviation by the appropriate normal distribution factor.
In some cases a method equivalent to the variance covariance approach is used to
calculate VAR. This method does not generate the variance covariance matrix and
uses the following approach:
1. Separate the portfolio in a long side and a short side.
2. Calculate the return series for the long side and the short side.
3. Use the return series to calculate the correlation and variances for the long and
short sides
4. Use the results in (3) to calculate the VaR.
The modified approach can be used where, due to the nature of the institutions
strategies, a number of positions would net close to zero on a portfolio basis and
also where the set of securities employed is so large that a variance covariance
approach would have significant resource/time requirements.
Historical Simulation Method for calculating Value at Risk (VaR)

It applies the historical (100 days) changes in price levels to current market prices in
order to generate a hypothetical data set. The data set is then ordered by the size of
gains/losses. Value at Risk (VAR) is the value that is equaled or exceeded the required
percentage of times (1, 5, 10).
Historical simulation is a non-parametric approach of estimating VAR, i.e. the returns
are not subjected to any functional distribution.
VAR is estimated directly from the data without deriving parameters or making
assumptions about the entire distribution of the data.
This methodology is based on the premise that the pattern of historical returns is
indicative of future returns
Monte Carlo Simulation for calculating Value at Risk (VaR)

The hypothetical data set used is generated by a statistical distribution rather
than historical price levels. The assumption is that the selected distribution
captures or reasonably approximates price behavior of the modeled securities
A Monte Carlo simulator uses random numbers to simulate the real world.
A Monte Carlo VaR model using the following sequence of steps
1. Generate randomly simulated prices
2. Calculate daily return series
3. Repeat the steps in the historical simulation method described below
Implementing Value at Risk (VAR)

The objective of a Value at Risk (VAR) implementation is to perform daily VAR analysis of
positions within a portfolio.
Such a process would be the first step in shifting the current emphasis from calculating
VaR to managing VAR. Within the process the focus should be on:
Positions with low coverage levels.
Positions with VAR beyond a set threshold.
Positions with significant VAR changes.
VAR analysis for the Desk. (All clients, All accounts, All positions)
Calculating VAR
Our sample portfolio that we will use for calculating Value at Risk (VAR) consists of
the following 4 items:
100 shares of ONGC
5 barrels of Crude Oil
1 foreign exchange denominated asset with market value of USD 10 on 5
th
March
2010.
100 units of 3-year RF with issue date of 19
th
February 2009 and coupon rate of
11.25%. This means that the outstanding term of the bond is 1.96 years.
We are calculating Portfolio Value at Risk (VAR) on the 5
th
of March 2010 at the end
of the day
The following steps are common to all the above mentioned Value at Risk (VAR)
approaches:
Step P1: Determine look back period for Value at Risk
Determine the period over which the risk is to be evaluated. For illustration purposes let
us assume a look back period of 5 days from 1
st
March 2010 to 5
th
March 2010. In practice
window lengths cover a wider duration, such as 6 months, 1 year, etc.
Step P2: Obtain the daily times series data for each risk factor for the determined look
back period for Value at Risk
ONGC WTI FX Rf 1 yr % Rf 2 year %
1/3/2010 100.3 4799.36 47.85 8.27 8.33
2/3/2010 100.41 4806.63 47.87 8.27 8.33
3/3/2010 100.28 4799.40 47.86 8.26 8.32
4/3/2010 99.07 4735.55 47.8 8.25 8.32
5/3/2010 99.18 4730.89 47.7 8.25 8.33
Adjustments to original time series data for Value at Risk
The interest rate risk factors, need to be adjusted to take into account the portfolios
exact exposure to this risk factor.
The rate series will first be interpolated based on the outstanding term to maturity of
the bond and then will be converted into a price series which will be used in the actual
VAR calculation:
The detailed steps to this process are :
Determine the outstanding term of the bond. This is calculated as follows:
Calculate an interpolated rf rate series for this outstanding term. Interpolation will
be done using the following formula:
T= outstanding term =1.96 years
T
1
=rounded down value of the outstanding term = 1 year
T
2
= T
1
+1 =2 years
Rf
interpolated
= (T2 T)*Rf
1 year
+ (T T
1
)*Rf 2 year / (T
2
-T
1
)
= (2-1.96) *8.25+(1.96-1)*8.33/(2-1)

1/3/2010
8.3276
2/3/2010
8.3276
3/3/2010
8.3176
4/3/2010
8.3172
5/3/2010
8.3268
Rf interpolated
Calculate the price of the bond at each data point using
Settlement date = Revaluation date = 5
th
March 2010
Maturity Date =19
th
March 2012
Coupon Rate = 11.25%
Yield = Rf_interpolated (%) applicable to that data point
Redemption value = 100
Coupon payment frequency = 2
Basis = Actual/365
where:
t = number of days from settlement to next coupon date.
E = number of days in coupon period in which the settlement date falls.
N = number of coupons payable between settlement date and redemption date
A = number of days from beginning of coupon period to settlement date.
The resulting bond price series works out to:
3/1/2010 105.3777
3/2/2010 105.3777
3/3/2010 105.3968
3/4/2010 105.3976
3/5/2010 105.3793
Calculate a return series from the time series data for Value at Risk
A return series is derived from the given time series data by taking the natural
logarithm of the ratio of successive prices /rates
ONGC WTI FX Rf prices
3/2/2010 0.1096% 0.1514% 0.0418% 0.0000%
3/3/2010 -0.1296% -0.1504% -0.0209% 0.0181%
3/4/2010 -1.2140% -1.3394% -0.1254% 0.0007%
3/5/2010 0.1110% -0.0985% -0.2094% -0.0174%
Calculate a return series for the portfolio
In order to evaluate the VaR for the portfolio, the return series for the portfolio will be
required. This is derived by calculating a weighted average return series using the
individual return series for each instrument in the portfolio. This will be calculated as
follows:
Calculate the weights of the respective instruments in the portfolio on the revaluation
date, where weight = value of the instrumenttotal value of the portfolio. The weights
for the portfolio are given below:
ONGC 100 Shares 9918.00 20.29%
WTI 5 barrels 23654.4 48.39%
FX 100 asset of USD 100 4770 9.76%
3 yr Rf 100 Units 10537.9 21.56%
48880.36 100.00%
The return series for the sample portfolio
3/2/2010
3/3/2010
3/4/2010
3/5/2010
0.0996%
-0.0972%
-0.9066%
-0.0493%