L ECTURE 3: V ALUE - AT -R ISK (VAR) II

VaR is important for regulators, as banks have to report VaR every day. For corporations it can offer valuable insight in risk, because VaR can be split into components. Also, derivatives must be taken into account for. For asset managers, it shows how much risk they (may) take (for example in Luxemburg, max VaR for funds is 20%). The Delta-normal method, VaR = . For historical simulation, with current portfolio weights the

performance is measured as if the same portfolio had been held one year ago, or three days. Then these returns are sorted, and the 5% VaR is the 5% worst case. The Monte Carlo simulation looks very similar to the historical simulation, but the historical returns are replaced with newly created returns. A distribution is assumed. The only difference between historical simulation is the way the returns are captured (passed returns vs. created returns). Correlations are included in historical simulation, because every time all returns are viewed on the same day. Because of the Basel agreement, banks need to report their VaRs. They can choose between the standard model, or to use an internal model (they can even choose for a hybrid model, in which everything is done independently). The capital to be set aside is either the last VaR or the average VaR of the last 60 days multiplied by the hysteria factor (this k is 3, so normally the last part accounts for the amount to be reserved). The Basel committee only allows the use of internal models conditional upon rigorous backtesting. There is an obvious conflict of interest, because the bank will want to have the lowest reserve possible, and the regulator wants the safest scenario. The regulator wants to catch the most banks cheating, but must avoid penalizing banks that did well. This is the balance between a type 1 error, which is the chance of rejecting a correct model, and a type 2 error being the chance not rejecting an incorrect model. The VaR horizon is 1 day, with a 99% confidence interval. Last years VaRs need to be given (250 days) and the exceptions are counted. Basel starts investigating if the number of exceptions is over 4. With p = 0.01 and t =250, the type 1 error is 10,8%. When a distribution is made for p=0.03 and t = 250, the type 2 error is 12.8%. If the threshold is increased, the type 1 error is lowered, but the type 2 error increases. Decreasing the threshold leads to the opposite. Kupiecs confidence regions show the amount of exceptions to be allowed wit h a fixed type 1 error (5%). With this fixed type 1 error, the type 2 error can be decreased by either measuring more data or increasing the confidence level (5% VaR is more reliable than 1%, because you are less in the outer tail). A VaR can also have its own confidence interval. A VaR that is 95% of the time between 15-25 mln is more reliable than a VaR thats between 1 -100 mln. In table 5.3, a sample is taken from random standard normal values, and it gives more accurate numbers than with historical simulation. Assuming the distribution is normal, the Delta-normal method is more accurate (because all observations are used to calculate volatility). The Deltanormal method uses a Delta/Local valuation, where the other methods use a full valuation. With lineair exposure, the first derivative is taken, and that is extrapolated (thus only locally viewed). In a full valuation, a lot of possible outcomes are measured. The Delta-Normal method needs linear exposure and normality. There is a trade-off between correlations and non-linearities. When exposed to many risk factors, a local valuation is easier, but for option trading books with limited sources of risk, a full valuation may be necessary.

Nick Leeson Case Nick Leeson was a trader on Nikkei futures in Singapore with the Barings Bank. He was in charge of both the trading and the settlement (nobody checked him). At some point one of the members of Nicks team made a

mistake for $20 000, and he protected this employee by opening an account and storing the loss(#88888). Later he stalled his own losses there. Management didnt segregate his duties, didnt supervise, didnt recognize unusual profits, didnt understand and didnt conduct further investigation. Leeson sold both put and call options on the Nikkei. If thats done with the same strike price, his payoff was a straddle (having the max. profit with no market change, and the more losses the larger the index change). He sold 35 000 calls and puts (where each option was on 500 Yen times the index). In the Black-Scholes formula, every parameter is annualized. For non-linear contracts the Delta-Normal VaR = (this is local valuation). With this approximation, as the is 0, the risk is 0. The Delta-Gamma approximation also looks at the second derivative. The valuation is still local, but the change in the derivative is also captured. In this case, VaR is formulated as: . With this approximation, the VaR increases to $ 8.5 million. With the Monte Carlo simulation there is a full valuation. It assumes the index follows a normal distribution with mean 0 and stdev of 1.26% per day. This means that . Then, 10 000 random numbers are drawn, and for each, the new price is calculated. Out of those 10 000 gains/losses, the 5% quantile adjusted for mean is the VaR value. If moving one day ahead, maturity will decrease. Riskmetrics assumes the mean is zero, because most of the time, the measurement error is larger than the benefit of including it. With this method, the VaR is 10,5 mln. To change to historical simulation, one needs to put in the returns of the index from the past to the current value of the index. The Delta-Normal method is fast and efficient for large portfolios but with optionality it fai ls. The Greeks method can increase precision when optionality is a component but it has few sources of risk. With substantial option components, Monte Carlo simulation is the best way to go. Historical simulation only uses one path, which is assumed to represent the future. It does also not account for predictability in volatility. Its quality critically depends on the length of historical period and it is hard to measure for large portfolios. The Monte Carlo simulation comes with computational costs, has much to implement on a frequent basis and holds the risk that models are wrong. If a portfolio is diversified over more indices, the returns are probably correlated, but there are also tricks to make a correlated series.