4.2.2 Calculating and Applying VaR

2. Calculating and Applying VaR

2.1 Linear and Non-linear Derivatives

Linear derivatives has a linear relationship between underlying risk factors and derivative instruments. The transmission parameter($\delta$) needs to be constant(e.g. forward, futures).

$$\Delta P_{\text{Linear Derivative}}=\delta \times \Delta S_{\text{Risk Factor}};{\text{VaR}}_{\text{Linear Derivative}}=\delta \times {\text{VaR}}_{\text{Risk Factor}}$$

Suppose you have a long forward position on an underlying stock maturing in 3 months. The daily $95\%\text{VaR}$ of the stock is 2 million. What is the daily $95\%\text{VaR}$ of the forward position?

${\delta }_{\text{Forward}}=1$

${\text{VaR}}_{\text{Forward}}=1\times {\text{VaR}}_{\text{Underlying Stock}}=2\text{million}$

Nonlinear derivatives has a changing relationship between underlying risk factors and derivative instruments depending on the state of underlying asset. The transmission parameter($\delta$) is inconstant(e.g. option, bond).

$$\Delta P_{\text{Non-linear Derivative}}=\delta \times \Delta S_{\text{Risk Factor}};{\text{VaR}}_{\text{Non-linear Derivative}}=\delta \times {\text{VaR}}_{\text{Risk Factor}}$$

2.2 Delta Normal Approach

2.2.1 Delta approximation

Delta normal approach(Delta approximation) is based on the risk factor’s deltas of a portfolio and assumes normal distributions for the risk factors.

Steps to calculate the $\text{VaR}$ of standalone non-linear derivatives.

• Step 1: Calculate the $\text{VaR}$ of the underlying risk factor.
• Step 2: Use delta with respect to the underlying to transmit the risk factor $\text{VaR}$ to the nonlinear derivatives $\text{VaR}$.

$${\text{VaR}}_{\text{option}}=|\Delta |\times {\text{VaR}}_{\text{stock}}$$

$${\text{VaR}}_{\text{bond}}=|-D\times P|\times {\text{VaR}}_{\text{yield}}$$

Louise wants to use delta normal approach to estimate the $\text{VaR}$ of a call position. The call option is at-the-money and the underlying stock is trading at USD $23$ with daily volatility $2.5\%$. Please calculate the daily dollar $\text{VaR}$ of this call option at $99\%$ confidence level.

${\text{VaR}}_{\text{stock}}=|0-2.33\times 2.5\%|\times 23=1.3398$

When a call call option is at the money , $\Delta$ is 0.5

${\text{VaR}}_{\text{option}}=|\Delta |\times {\text{VaR}}_{\text{stock}}=0.5\times 1.3398=0.6699$

Steps to calculate the $\text{VaR}$ of a portfolio:

• Calculate individual risk factors’ mean and standard deviation and their correlation between each other.
• Calculate the means and volatility of the portfolio
• Calculate the portfolio’s $\text{VaR}$ assuming normality of value change of the portfolio.

$$\text{VaR}(X\%)=|{\mu }_{\text{portfolio}}-Z_{X\%}\times {\sigma }_{\text{portfolio}}|$$

Many pension fund are using $\text{VaR}$ to measure their portfolio risk. Tao, FRM, is a risk analyst of Pluto Pension Fund. In his routine work, he will send risk report of large portfolios to his manager on daily basis. Consider a portfolio consisting of $ $20$ million invested in Stock A and $ $40$ million invested in Stock B. Assuming that returns are normally distributed. Daily volatilities of A and B are $0.5\%$ and $2\%$ and daily returns are $0\%$. The correlation between two stocks is $0.25$. What is the daily dollar $\text{VaR}$ with $95\%$ confidence level of the portfolio?

${\sigma }_p^2=w_1^2{\sigma }_1^2+w_2^2{\sigma }_2^2+2w_1{w}_2{\sigma }_1{\sigma }_2{\rho }_{1,2}$

${\sigma }_p^2=20^2\times 0.5{\%}^2+40^2\times 2{\%}^2+2\times 20\times 40\times 0.5\%\times 2\%\times 0.25\to {\sigma }_p=0.83\text{million}$

$\text{VaR}(X\%)=|{\mu }_{\text{portfolio}}-Z_{X\%}\times {\sigma }_{\text{portfolio}}|=1.65\times 0.83=1.37\text{million}$

2.2.2 Delta-gamma approximation

Taylor Series approximation(Delta-gamma approximation): the change in the derivative value is approximated by slope and curvature. The first derivative is delta linear approximation and second derivative is the gamma correction.

Delta-gamma approximation cannot provide accurate approximation for portfolio with non-linear derivatives such as MBS, barrier options, as the normal distribution assumption for the change of risk factors does not translate into the normal distribution assumption for the change of portfolio value.

Although adding gamma can work much better and the result is a quadratic model. But there are no easy-to-use analytic results for quadratic model.

$${\text{VaR}}_{\text{bond}}=|-D\times P|\times {\text{VaR}}_{\text{yield}}-\frac{1}{2}\times C\times P\times {\text{VaR}}_{\text{yield}}^2$$

$${\text{VaR}}_{\text{option}}=|\Delta |\times {\text{VaR}}_{\text{stock}}-\frac{1}{2}\times \Gamma \times {\text{VaR}}_{\text{stock}}^2$$

注意是减去 gamma correction

Stephen Ross, a trader of Neptune Security, has a call option position on CAC-40 index. The index is $5345$ currently. Stephen uses BSM model to analyze the option, which has $N(d1)=0.67$, $N(d2)=0.576$. In this call option contract, every point of index values $€5$. The daily volatility of the underlying index is $0.45\%$. What should be the $95\%$ daily dollar $\text{VaR}$ of this call option under delta-normal approach?

${\text{VaR}}_{\text{stock}}=1.65\times 0.45\%\times 5345\times 5=198.433$

$\Delta =N(d1)=0.67$

${\text{VaR}}_{\text{option}}=|\Delta |\times {\text{VaR}}_{\text{stock}}=0.67\times 198.433=132.95$

2.3 Historical Simulation

Historical simulation is a non-parametric method, where the future behavior of the underlying market variable is determined in a very direct way from their past behavior. These scenarios can be evaluated using full revaluation.

Steps of historical simulation:
(1) Identify risk factors (equity price, interest rate etc.) on which the value of the portfolio under consideration depends.

• Percentage change(equity price, foreign exchange)
• Actual change(interest rate, credit spread)

(2) Collect daily data on the behavior of the risk factors over a period in the past.

Day	Stock Price (USD)	Int. Rate	…	Port.Val. (USD million)
0	$50$	$2.52\%$	…	$72.1$
1	$52$	$2.54\%$	…	$72.5$
2	$46$	$2.55\%$	…	$70.4$
…	…	…	…	…
498	$60$	$2.30\%$	…	…
498	$60$	$2.32\%$	…	$75.3$
500	$63$	$2.36\%$	…	$76.3$

(3) Create scenario by assuming that the change in each risk factor over the next day corresponds to a change observed during one of the previous days.

Scenario	Stock Price (USD)	Int. Rate	…	Port.Val. (USD million)	Loss (USD million)
1	$65.52$	$2.38\%$	…	$76.8$	$-0.5$
2	$55.73$	$2.37\%$	…	$71.7$	$4.6$
…	…	…	…	…	…
499	$63.00$	$2.38\%$	…	$75.3$	$1$
500	$66.15$	$2.40\%$	…	$76.7$	$-0.4$

(4) Sort the loss based on the scenarios and calculate VaR or ES for any given confidence level.

Scenario	210	195	2	23	48	367	235	…	…	…
Loss(USD millions)	7.8	6.5	4.6	4.3	3.9	3.7	3.5	…	…	…

${\text{ES}}_{\text{daily}}(1\%)=(7.8+6.5+4.6+4.3)/4=5.8\text{million}$

${\text{VaR}}_{\text{daily}}(1\%)=3.9\text{million}$

Advantages

• It is easy to implement and not exposed to model risk.
• Actual market prices are accumulated for full revaluation.
• All correlations risk factors are included in the prices.

Disadvantages:

• It gives equal weight to all the observations.
• Historical data may not be a good forecast for future.
• It cannot reflect the new volatility and correlation changing in the market condition instantly.

2.4 Monte Carlo Simulation

Monte Carlo simulations generate scenarios by taking random samples from the distributions assumed for the risk factors (rather than using historical data). Monte Carlo simulation is a full revaluation method.

Steps of Monte Carlo Simulation:
(1) Value the portfolio today using the current values of the risk factors.

(2)Sample once from the multivariate normal probability distribution for the change of risk factors. (e. G. Stock price interest rate change)

(3) Use the sampled values of the change of risk factor to determine the values of the risk factors at the end of the period under consideration (usually one day).

(4) Revalue the portfolio using these risk factor values. Subtract this portfolio value from the current value to determine the loss.

(5) Repeat steps 2 to 5 many times to determine a probability distribution for the loss.

Advantages:

• Can generate correlated scenarios and model the correlations among different risk factors based on a statistical distribution.
• Work for both linear and non-linear portfolio.

Disadvantages:

• There is model risk for the generation of statistical distribution on the risk factor.
• Computationally intensive and thus quite slow
• The correlation and standard deviation for the risk factor in the past may not be a good indicator of the future.

Summary

Category	Historical Simulation	Delta Normal Approach	Monte Carlo Simulation
Full Revaluation	Yes	No	Yes
Model Risk Distribution assumption	No	Yes	Yes
Computationally intensive	Yes	No	Yes

2.5 Correlation Breakdown

During periods of heightened volatility, correlations can be very different from those under normal market conditions. Correlations usually increase under stressed market conditions. This is sometimes called a correlation breakdown.

When calculating $\text{VaR}$ or $ES$, we are concerned estimating what would happen under extreme market conditions. Therefore, we should try and estimate the correlation in such case rather than in normal market conditions.

2.6 Worst case analysis

Worst case analysis: an analyst will calculate statistics for worst-case results.

Monte Carlo simulation can be used to calculate the expected worst-case result over 52 weeks, the 95th percentile of the worst-case result.

It should not be regarded as an alternative to $\text{VaR}$ and $ES$.