VaR-Model Based Approach

Model Based Approach

The model-based approach assumes a model for the joint
distribution of changes in market variables (risk factors) and
uses historical data to estimate the model parameters.
The mean and standard deviation of the value of the portfolio
can be calculated from the mean and standard deviation of
the returns on the risk factors and the correlations between
those returns.
The VaR calculation is based on the assumption that
underlying variables and the change in the value of the
portfolio are normally distributed.

Delta Normal VaR

The Delta-Normal Model applies to portfolios of linear
instruments.
Linear instruments have returns proportional to the returns
of risk factors.
The relation of instrument returns to factor returns is
measured by sensitivities (deltas) and these sensitivities
are assumed to be constant.
Asset returns are assumed to be normally distributed

Delta Normal VaR

The delta-normal VaR technique decomposes assets or portfolios as a
linear combination of elementary positions.
Each of these elementary positions are mapped to a single factor that
influences its value.
Using sensitivities to risk factors, the variation in the portfolio value is
modeled as a linear function of the variations in risk factors.
The volatility of the portfolio is determined as the volatility of a linear
function of random factor returns.

Normal distribution and its known quantiles are used to convert

volatility into a VaR estimate.

Delta-Normal VaR
Suppose there is a single underlying which has a
mean return of x= (S/S), where the price of the
underlying is S, volatility is and the instrument
has a delta with respect to the underlying, then
the change in the value of the instrument is
P= S or Sx.
The volatility of the instrument is P=S

Delta-Normal VaR
When there are more than one underlyings, the ith
underlying has a mean return of xi (Si/Si), where Si is
the price of the underlying. volatility of i and the asset has
a delta i with respect to the ith underlying, then the
change in the portfolio value has a mean of
n

P i Si xi
i 1

The variance of P, depends on the covariances ij or the

correlations ij of the underlyings. The formula is
n

2P i j Si S j i j i , j
i 1 j 1

Delta-Normal Approximation
Advantages
Computational Attractiveness: Portfolios with several
thousand positions spread across hundreds of underlyings can
be handled very fast.
Modest data requirement: Only volatilities of underlyings
and pair-wise correlations required.
An organization called Risk Metrics provides daily estimates
of volatilities and correlations for hundreds of stock indices,
exchange rates, interest rates, commodity prices to facilitate
use of these methods

Delta-Normal Approximation
If the portfolio has only cash, forward or futures
positions in the various underlyings, then the
formulas for mean and variance of the portfolio
values are exact.
If the portfolio has option positions, then these
formulas are approximate as they ignore the effect
of gamma, vega and other greeks.

Mapping Fixed Income Securities

When the portfolio contains bonds, each bond can be
decomposed into a portfolio of zero-coupon bonds by
treating each cash flow as a zero coupon bond maturing
on the cash flow date.
When the portfolio contains a large number of bonds and
other fixed-income securities, the number of cash flow
dates becomes very large and this approach leads to a very
large number of zero-coupon bonds in the decomposition.

Handling Fixed Income Securities

It becomes impractical to treat each of these bonds as a
different underlying.
This is because delta-normal method requires the volatility
of each underlying and also the correlation of each
underlying with each other underlying.
Some simplifications are necessary
One can assume only a parallel shift in the yield curve and
define only one market variable: the size of the parallel
shift.
The changes in the value of the bond portfolio can then be
calculated using the approximate duration relationship.

Handling Fixed Income Securities

The change in the value of the portfolio for a small change
y in the yield is approximately P DPy
where P is the value of the portfolio, P is the change in
P in one day, D is the modified duration of the portfolio
The standard deviation of daily change in the value of the
portfolio equals Dpy where y is the standard deviation of
the daily change in the yield
This method is not quite accurate as it does not take into
account non-parallel shifts in the yield curve. An alternative
approach Cash Flow Mapping is used.

Cash-Flow Mapping
It involves choosing as underlyings the prices of zerocoupon bonds with standard maturities: 1 month, 3
months, 6 months, 1 year, 2 years, 5 years, 7 years, 10
years and 30 years.
For the purposes of calculating VaR, the cash flows from
instruments in the portfolio are mapped into cash flows
occurring on the standard maturity dates.
Suppose that zero rates, daily bond price volatilities and
correlations between bond returns are as shown in the
following Table.

Cash-Flow Mapping
Maturity

3-month
6-month
1-year
bond
bond
bond
--------------------------------------------------------------------------------------Zero rate
(% with ann. Comp.)
5.50
6.00
7.00
Bond price volatility
(% per day)
0.06
0.10
0.20
---------------------------------------------------------------------------------------Correlation between
Daily returns
3-month bond
1.0
0.9
0.6
6-month bond
0.9
1.0
0.7
1-year bond
0.6
0.7
1.0

Cash-Flow Mapping
Consider a Rs. 1 million position in a Treasury bond lasting 0.8 years
that pays a coupon of 10% semi-annually.
A coupon is paid in 0.3 years and 0.8 years and the principal is paid in
0.8 years.
The bond is regarded as Rs.50,000 position in a 0.3 year zero-coupon
bond plus a Rs. 1,050,000 position in a 0.8 year zero-coupon bond.
The position in the 0.3 year bond is replaced by an equivalent position
in 3-month and 6-month zero coupon bonds and the position in the 0.8
year bond is replaced by an equivalent position in 6-month and 1-year
zero coupon bonds.
Thus, the position in the 0.8 year coupon bond is for VaR purposes
regarded as a position in zero-coupon bonds having maturities of 3
months, 6 months and 1 year.

Cash-Flow Mapping
For the cash flow of Rs.1,050,000 to be received in 0.8
years, the zero rate is interpolated as 6.6% and the
volatility as 0.16%
The present value of Rs.1,050,000 to be received in 0.8
years is:
1, 050, 000
Rs.997, 662
0.8
1.066
Suppose we allocate of the present value to the 6-month
bond and (1-) of the present value to the 1-year bond.
We can find the value of by equating the variances:

0.00162 0.0012 2 0.0022 (1 ) 2 2 0.7 0.001 0.002 (1 )

Cash-Flow Mapping
The value of is calculated as 0.320337.
This means that 32.0337% of the value should be allocated to a
6-month zero-coupon bond and 67.9663% should be allocated
to a 1-year zero-coupon bond.
The 0.8 year bond worth Rs.997,662 is therefore replaced by a
six- month bond worth Rs.319,589 (0.320337*Rs.997662) and
by a 1-year bond worth Rs. 678,074 (0.679663*Rs.997,662).
The present value of Rs.49,189 of Rs,50,000 at time 0.3 years
can , similarly, be mapped to a position worth Rs.37,397 in a 3month bond and a position worth Rs.11,793 in a 6-month bond.

Cash-Flow Mapping
The summary of the cash flow mapping is given below:
-----------------------------------------------------------------------------Rs.50,000 Rs.1,050,000 Total
received in
received in
0.3 years
0.8 years
--------------------------------------------------------------------------------Position in 3-month bond
37,397
37,397
Position in 6-month bond
11,793
319,589
331,382
Position in 1- bond
678,074
678,074

Cash-Flow Mapping
The variance of the position based on the respective
volatilities and correlations is Rs.2,628,518 and the
standard deviation is Rs.1621.3.
The 10-day 99% VaR is:

1621.3 10 2.33 Rs.11,946

The cash-flow mapping approach has the advantage that it
preserves both the value and the variance of the cash flow.

Principal Components Analysis

PCA is a technique of handling the risk arising from groups of
highly correlated market variables.
Principal components are linear combinations of standard factors
(of a factor model). However these components are independent of
each other or orthogonal.
PCA applies when we have highly correlated data due to which a
large fraction of the total variance is explained by the first few
principal components.
A major application of PCA is modeling of the term structure of
interest rates, since all of them are highly correlated.

Principal Components-Example
The following principal components are linear
combinations of swap rates of different maturities . These
are derived using historical data.
PC 1

PC2

PC3

1-year

0.216

-0.501

0.627

2-year

0.331

-0.429

0.129

3-year

0.372

-0.267

-0.157

4-year

0.392

-0.110

-0.256

5-year

0.404

0.019

-0.355

7-year

0.394

0.194

-0.195

10-year

0.376

0.371

0.068

30-year

0.305

0.554

0.575

Factor Loadings
The coefficients of factors in a principal component are called factor
loadings.
These are the correlations between the original variables and the factors.
The components have the property that the factor scores (the sensitivity
of a position to a component) are uncorrelated across the data.
For example, the first factor score (amount of parallel shift) is
uncorrelated with the second factor score( amount of twist) across all days

Variance of Factor Scores

The variance of the factor scores have the property that
they add up to the total variance of the data.
The importance of a factor is measured by the standard
deviation of the factor score. The factors are generally
listed in the order of their importance.
For example , the standard deviations of factor scores for
PC1, PC2 and PC3 are 17.55, 4.77 and 2.08 respectively.

Interest Rate Sensitivities

When positions are mapped to standard maturities, the
sensitivities of the positions due to unit shocks in the
interest rates are given by their deltas (in terms of
monetary value)
For example, the following Table shows the change in
portfolio value (in $ millions) for a one-basis point rate
move
1-year rate

4-year rate

5-year rate

7-year rate

10-year rate

+10

+4

-8

-7

+2

Factor Sensitivities
These sensitivities have to be converted into
sensitivities to each principal component.

The sensitivity of a position to a principal

component in monetary value is the product of
each position delta by the factor loading.

Factor Sensitivities
The factor score of PC1 (delta exposure to PC 1) in millions of
dollars per unit of the component is:
10 x 0.372 +4 x 0.392 + (-8) x 0.404 +(-7)x 0.394 +2 x 0.376
=- 0.05
The factor score of PC 2 in millions of dollars per unit of the
component is:
10 x (-)0.267 +4 x (-)0.110 + (-8) x 0.019 +(-7)x 0.194 +2 x
0.371 = - 3.87

Value at Risk
Denoting PC1 by f1 and PC2 by f2, the change in portfolio value is
approximately
P =-0.05 f1-3.87 f2
The standard deviations of factor scores for PC1, PC2 are 17.55
and 4.77, respectively and the factor scores are uncorrelated
The standard deviation of P is:

P 0.052 17.552 3.87 2 4.77 2

= 18.48

The one-day 99% VaR is 18.48 x 2.33 =42.99

Mapping Forward Contracts

A forward foreign exchange contract maturing at time T
can be regarded as exchange of a foreign zero-coupon
bond maturing at time T for a domestic zero-coupon bond
maturing at time T.
For the purposes of calculating VaR, the forward contract
is treated as a long position in the foreign bond and a short
position in the domestic bond (the foreign bond is valued
in domestic currency).
Each bond can be handled using a cash-flow-mapping
procedure so that it is a linear combination of bonds with
standard maturities.

Mapping Interest Rate Swaps

An interest rate swap can be regarded as the exchange of a
floating-rate bond for a fixed-rate bond.
The fixed-rate bond is a regular coupon bearing bond.
The floating-rate bond is worth par just after the next
payment date. It can be regarded as a zero-coupon bond
with a maturity date equal to the next payment date.
The interest rate swap, therefore reduces to a portfolio of
long and short positions in bonds and can be handled using
a cash-flow mapping procedure.

Handling Options
When a portfolio includes options, the delta-normal model is
an approximation. It does not take into account the gamma
of the portfolio.
A long call option has a positive gamma and a short call
option has a negative gamma.
The probability distribution of the call option price has a
positive skew in case of a positive gamma and a negative
skew in case of negative gamma, when the probability
distribution of the price of the underlying asset is normal.
Assumption of a normal distribution for the call option price
would lead to either a high or low calculation of VaR.

Delta-Gamma Approach
For a more accurate estimate of VaR than that given by the
delta-normal model, a quadratic model (delta-gamma
approach) is used that takes into account the delta and
gamma of the option position.
Consider a portfolio dependent on a single asset whose
price is S. Suppose and are the delta and gamma of the
portfolio and return is x = S/S

S
(x22

S
)2x2

Delta-Gamma Approach

For a portfolio dependent on a single asset price it is approximately

true that
so that

To account for skewness in the probability distribution of option

prices, the Cornish Fisher expansion formula is used.

This formula provides the quantiles of a non-normal distribution,

given the moments of the distribution.

Delta-Gamma Approach
When x is assumed to be normal, the Moments are

E (P ) 0.5S 2 2
E (P 2 ) S 2 2 2 0.75S 4 2 4
E (P 3 ) 4.5S 4 2 4 1.875S 6 3 6

Delta-Gamma Approach
From the moments of the probability distribution of P, the
following quantiles can be calculated
P E (P)
2
2

E P E (P )

2
P

3
2
3

3
E

P
P
3

P 1/ P E P P

P3

Adjustment for Skewness in DeltaGamma VaR model

The multiplier (-2.33 for 99% VaR) is modified using the
Cornish Fisher expansion formula
w = z + 1/6(z2 -1) P
where w = corrected quantile, z=quantile based on
normal distribution, P =skewness
The VaR is then given by P +wqp,

Delta-Gamma Approach for Multiple

Underlyings
Delta Gamma Approximation for Multiple Underlyings
n

P i Si xi
i 1

i 1 j 1

1
i , j Si S j xi x j
2

i,j is the cross-gamma that measures the change in delta

of i with that of j.
2
i, j

P
Si S j

Monte Carlo Simulation (Partial Revaluation)

The usual Monte-Carlo Simulation involves full
revaluation of all positions and consumes a lot of time.
It is also possible to implement a hybrid (or partial)
Monte Carlo simulation where the pricing model is
replaced by the Taylor expansion (delta-normal or deltagamma-rho-theta method)
This hybrid approach has the advantage of being less
computer intensive because delta-gamma method is related
to underlyings rather than positions.

Monte Carlo Simulation (Partial Revaluation)

Under partial revaluation, instead of revaluing each
position in the portfolio, the market prices generated by a
simulated scenario are used to calculate the scenario
portfolio value Pi using the following equation:
n

1
P i S i xi i , j S i S j xi x j
i 1
i 1 j 1 2