Risk Management

Session - 5 Session - 6

Conducted by : Keta Kurkute

RECAP
Covariance for a single position
VAR = V X P Where, V= Volatility; P = Position Value

Mathematically, VAR (X%) = zX%.

VAR(X%) = the X% probability value at risk zX%= the critical z-value based on the normal dist. & the selected X% probability = the SD 0f daily returns on % basis

VAR (X%) dollar basis = VAR(X%)decimal basis X asset value = zX% X P VAR (X%)J-days = VAR (X%)J-day J

April 10, 2011

Session 5 & 6

VAR for a Portfolio

 We have considered two of the three key drivers of VAR
Volatility & Holding Period

 The third constituent Portfolio Diversification  Portfolio diversification describes the extent that the risk in a portfolio is reduced by holding a diversity of assets

April 10, 2011

Session 5 & 6

contd

 Age-old concept : Not putting all ones eggs in one basket  Correlations between assets are used to describe how the price changes in assets are related to each other  Correlation are always between -1 & 1  Correlation = 1 , two assets always move in line  Correlation = - 1 , two assets always move in opposite direction

April 10, 2011

Session 5 & 6

VAR for a portfolio with two assets

 The diversification effect ( risk reduction) increases as the correlation reduces  VAR of a portfolio is simply the volatility of the portfolio

April 10, 2011

Session 5 & 6

VAR for uncorrelated & perfectly correlated positions

VAR for uncorrelated positions = VAR12 + VAR22 The other extreme is when the correlation is 1 means there is no benefit from diversification For the two asset portfolio, undiversified VAR will be = VAR1 + VAR2 Undiversified VAR is the sum of all the VARs of the individual positions in the portfolio when none of the positions are short positions

April 10, 2011

Session 5 & 6

Lets Solve
 Smith manages a portfolio of two invst: Long term corporate bonds & large capitalization stocks. Of the portfolios current value of $820 mio, Long term corporate bonds make up 40% & large capitalization stocks makes up 60%.The correlation between bonds & stocks is 0.55. Smith has estimated a VAR(5%) of 2.0% or 6.56 mio, for corporate bond position & 3.0% or $14.76 mio for large capitalization stock position. Calculate the Portfolio VAR(5%) on a % & dollar basis

April 10, 2011

Session 5 & 6

contd

 Sol:  Percentage basis  VAR (5%) portfolio = (0.42) (0.022)+ (0.62) (0.032)+2 (0.4) (0.6) (0.02) (0.03) (0.55) = (0.0005464) = 0.0233 =2.33% Dollar Basis  VAR (5%) portfolio = (6.56)2+ (14.76)2 +2 (6.56) (14.76) (0.55) (367.39936) = 19.16766 =$ 19.17 mio
Alternatively, It can be 0.0233 X 820 mio = 19.106 mio ( In case of dollar basis as the VARs are already given, we will not apply ratios & VAR in % to it)
April 10, 2011 Session 5 & 6 8

contd

 Ex.2: An analyst computes the VAR for two positions in her portfolio. The VARs : VAR1 = $2.4 mio & VAR2 = $1.6 mio. Compute VARP if the returns of the two assets are uncorrelated  Sol: For uncorrelated assets:
VARP = VAR12 + VAR22

=
=

(2.4)2 + (1.6)2

(8.32 mio)

= $ 2.8844 mio

April 10, 2011

Session 5 & 6

contd

 Ex. 3: An analyst computes the VAR for the two positions in her portfolio. The VARs : VAR1 = $2.4 mio & VAR2 = $1.6 mio. Compute VARP if the returns of the two assets are perfectly correlated
Sol: For perfectly correlated assets: = VAR1 + VAR2 = 2.4 + 1.6 = $ 4 mio

April 10, 2011

Session 5 & 6

10

VAR - Equally weighted portfolio of assets, same SD & correlations are equal
 Three assumptions:
The portfolio is equally weighted All the individual positions have same SD of returns The correlations between each pair of returns are the same

 The formula is then:

p=

1/N +(1-1/N)

Where: N = the number of positions = the SD that is equal for all N positions = the correlation between the returns of each pair of positions
April 10, 2011 Session 5 & 6 11

contd

 Ex. 1: A 2 X2 table is given where there is a small & large correlation ( ) column & a small & large sample size (N) row. Assuming that the SD of returns is 20% for both assets, calculate SD for the portfolio
Sample size/ correlation N=4 N = 10 = 0.1
P= P

= 0.5
P= P

? 11.40% ? P = 8.72% P

? 15.81% ? P = 14.83% P

April 10, 2011

Session 5 & 6

12

contd

 Ex.2: A portfolio has five positions of $2 mio each. The SD of the returns is 30% for each position. The correlations between each pair of returns is 0.2. Calculate the VAR using a Z value of 2.33.

Sol: The SD of the portfolio returns is:

p=

1/N +(1-1/N)

= 30% 1/5 +(1 -1/5)0.2 = 30% 0.36 = 18% The VAR in nominal terms is
 VARP = ZX% P = (2.33) (18%) ($10 mio) = $ 4,194,000

April 10, 2011

Session 5 & 6

13

VAR of a Portfolio Multiple Assets

If VAR needs to be calculated with some Z value, multiply the final number with it
April 10, 2011 Session 5 & 6 14

Calculation of VAR for a portfolio

 Consider the following portfolio:

 The volatilities of the three assets with 95% confidence is as follows:

April 10, 2011

Session 5 & 6

15

contd

April 10, 2011

Session 5 & 6

16

contd

April 10, 2011

Session 5 & 6

17

Matrix Multiplication
 Here we will multiply a 3x3 matrix (3 rows, 3 columns) to another 3x3 matrix (3 rows, 3 columns).  To calculate x11: x11 is the cell where first row merges with first column. So in order to calculate the result we will use the first row of Matrix A and first column of Matrix B.

 Now x11 can be calculated as x11 = a11xb11 + a12xb21 + a13xb31

April 10, 2011

Session 5 & 6

18

contd

 Step 2: To calculate x12 x12 is the cell where first row merges with second column. So in order to calculate the result we will use the first row of Matrix A and second column of Matrix B.

Now x12 can be calculated as x12 = a11xb12 + a12xb22 + a13xb32 Following the same procedure we will have to calculate values for all cells.

April 10, 2011

Session 5 & 6

19

contd

The rules for matrix multiplication are as follows:  The number of columns in A must equal the number of rows in B  The resultant matrix will have the same number of rows as A and the same number of columns as B.  The ijth element of C is equal to the `row-on-column' product of the ith row in A and the jth column in B. This is the critical rule to remember.

April 10, 2011

Session 5 & 6

20

contd

This gives VARP = $41,470, or $41,000 to two significant figures This means that on this portfolio it is expected that a loss greater than $41,000 can be expected on 5% of days, i.e. one day in 20. In practice the composition of any trading portfolio is likely to change daily (in fact almost constantly during the trading day) and Therefore the VAR is different for each end of day position.

April 10, 2011

Session 5 & 6

21

Lets Solve
 Ex. 2: A portfolio consists of assets A, B, C & D. The volatilities of four assets are as follows 6%, 5.2%, 4.5% & 8%, respectively. There are $ 4 mio, $2 mio, $6 mio & $ 10 mio invested in them respectively. The correlation matrix is as follows
A A B C D 1 0.5 0.25 0.30 B 0.5 1 0.4 0.1 C 0.25 0.4 1 0.6 D 0.3 0.1 0.6 1

 Compute the VAR of the portfolio using Z = 1.65

April 10, 2011

Session 5 & 6

22

contd

 Sol: Vector V is as follows

A 4 (0.06)=0.24 B 2(0.052)=0.104 C 6(0.045)=0.27 D 10(0.08)=0.8

 VARP= (0.24 0.104 0.27 0.8)

1 0.5 0.25 0.30

0.5 1 0.4 0.1

0.25 0.4 1 0.6

0.3 0.1 0.6 1

0.24 0.104 0.27 0.8

1.25218 VAR P= 1.65 X1.119008 mio = 1.8463 mio

= 1.119008 mio

April 10, 2011

Session 5 & 6

23

contd

 In practice correlations of -1 are fairly rare but correlations of close to 1 are common within product categories.  There are very high correlations between bonds with different maturities  For eg: There is a correlation of 0.99 between the yields of 5and 7-year USD treasuries.

April 10, 2011

Session 5 & 6

24

Portfolio Risk primary factors

 Asset Concentration
y As portfolio becomes heavily weighted towards one asset, portfolio risk increases

 Asset Volatility
y As the variance of assets within the portfolio increases, portfolio risk increases

 Asset Correlation
y As the correlation between assets increase towards +1, portfolio risk increases

 Systematic risk
y As the no. of assets within the portfolio becomes large, systematic risk becomes the more relevant factor for assessing additional assets

April 10, 2011

Session 5 & 6

25

Any Questions??

 ketakurkute@gmail.com 98704 36517