1

Chapter 6 Risk Measures and Models Selection

6.1 Percentiles
In an ordered array, the pth percentile of a set of data/ distribution is defined by
p(n+1)/100 ranked value
where n is the sample size.
Example 1(E) Refer to the following data:
2
3
3
7
11 15 18 19 21
th
(a) Find the 5 percentile, (b) Find the 30th percentile.

23

27

31

We will revisit percentiles when we discuss Section 6.5 Value at Risk.

6.2. Risk and Risk Measures
In the context of finance, risk can be defined as the possibility of suffering from loss/
less-than expected gain in an investment activity. Risk can be divided by (1)
Non-quantifiable & (2) Quantifiable. Quantifiable risk is characterized by measurable
probability and finite losses. We will solely focus on quantifiable risk.
To quantify risk, several risk measures will be introduced in subsequent sections of
this chapter.
6.3 Volatility
As we have seen in Chapter 5, volatility is the annualized/ daily standard deviation of
the returns of the investment. In general, the higher the volatility, the higher the risk
is.
6.4 Sharpe Ratio

Sharpe Ratio (SR) is defined as :

SR =

where r is the return on the investment,

r rf

rf is the risk free rate and is the volatility.

In other words, Sharpe ratio can be interpreted as the excess return per unit volatility
(risk). Under the same amount of risk, a higher excess return is more preferable. In
other words, we prefer to have a higher Sharpe ratio. If we assume a linear
relationship between return and risk, Sharpe ratio is simply the gradient of the Return
vs. Risk graph, where risk here is characterized by volatility:

6.5 Value at Risk (VaR)

Value at risk (VaR) is an extreme risk measure originally developed in 1990s. VaR
measures the worst expected loss over a given time interval under normal market
conditions at a given confidence level. For example, an annual VaR of $5M at a 95%
confidence level for an investment would suggest that only 5% of chance (i.e. once in
every 20 years, on average) would the annual loss exceed $5M.
In the context of returns, Return at Risk is perhaps a more appropriate term, although
the term VaR is used universally to represent both values and returns at risk.
In general, VaR (VaR at confidence level 1 ) is (th percentile) of an ordered
prices/ returns array. The negative sign here is to convert the negative returns into a
positive value of VaR.
If we assume the returns are normally distributed, then

VaR r z ,
Where Z~N(0,1), r is the mean return and is the return volatility.

For example, for 95% confidence interval, VaR0.05= r 1.645 .

6.6 Conditional Value at Risk (CVaR)/ Expected Shortfall (ES)

While VaR is a simple measure, it does not provide any information about the shape
of the tail distribution and the expected size of the loss beyond the confidence level.
Therefore, it can be regarded as a very unsatisfactory risk measure.

Conditional Value at Risk (CVaR), also known as Expected Shortfall (ES),

supplements the about information. It takes into account of the returns in
tail-distribution. It is the mean return (loss) condition on the return exceeding the
value of VaR:
1 n
CVaR
ri ,
nVaR i 1
where ris (i=1, 2,, nVaR) are the returns which are less than VaR and nVaR is the
number of returns which are less than VaR.
If we assume the returns are normally distributed, then
z

CVaR r
e 2
2

where r is the mean return and is the return volatility.

For example, for 95% confidence interval, CVaR0.05= r 2.0622 .

Example 2 (E) Based on the closing prices of MTR Corporation (0066) in 2013, find
the values of the abovementioned risk measures on returns (use Hang Seng Index as
the benchmark if necessary.): (a) Volatility, (b) Sharpe Ratio (let , (c) 5% Value at
Risk (VaR0.05), (d) 1% Conditional Value at Risk (CVaR0.01).
Example 3 (E) Based on the simulation in Chapter 5 Example 4, find the values of
the above risk measure on returns: (a) Volatility, (b) Sharpe Ratio (let rf =2.3%), (c)
1% Value at Risk (VaR0.01), (d) 2.5% Conditional Value at Risk (CVaR0.025).
6.7 Durations & Modified Duration
Unlike the previous risk measures, duration is a risk measure exclusively for fixed
income securities such as bond.
The timing of future payments is important in fixed income securities. In this
section we will be discussing some risk measures concerning the timing of the future
payments.
A. Duration
Let R1, R2,..,Rn be a series of payments made at the times 1,2,.,n. Then the

duration (also known as Macaulay duration), denoted by d , is given by

n

tv R
t

t 1
n

v R
t

t 1

Noted that:
(1) It can be proved (by differentiation) that the duration d is a decreasing function
of i. Therefore, duration decreases as interest rate increases.
(2) If there is only one future payment, then d is the point in time at which that
payment is made.

B. Modified Duration
We now consider the relationship between the rate of change in the present value of a
series of future payments as the rate of interest changes. Let this present value be
denoted by P(i), i.e.
n

t 1

t 1

P(i) vt Rt (1 i) t Rt

We now define the Modified Duration as follows:

P ' (i )
[P (i i ) P (i )] / i
v

P( i )
P( i )
where i is the change in interest rate.
The term P(i) measures the rate of change in the present value of the payments as the
rate of interest changes. Dividing by P(i) express this instantaneous rate of change
in units independent of the size of the present value itself. The minus sign is
necessary to make v positive, since P(i) is negative.
d
or d (1 i)v , i.e. modified duration is equal to
1 i
duration divided by 1 + i. Since i here is per period interest rate, we have a very

It can be shown that v

interesting (and convenient) result:

d v
if interest is compounded continuously!

C. Relationship between Interest Rate Risk and Duration/ Modified Duration

Recall that v is a measure of rate of change in the present value of the payments
with respect to the interest rate. Therefore, from v (or d if continuous
compounding), we are able to tell directly the bonds exposure to the interest rate risk.
For example, a bond with modified duration/ duration of 13 years would be expected
to gain 13% in market value if interest rate rises by 1%.
Example 4(E) Refer to Example 6 of Chapter 2:
Find the price of a $1000 par value (face-value) ten-year bond with coupons at
8.4% convertible semiannually, which will be redeemed at $1050. The bond is
bought to yield 10% convertible semiannually.
(a) Find the duration and modified duration of the payments.
(b) Interpret the meaning of these two durations in terms of the relationship between
bond price and interest rate changes.
(c) Verify the above interpretation by considering i equals to (i) + 0.5%, (ii)
-1.5%.

6.8 Models Selection and Normal Probability Plots

In Chapter 5, we assumed normal/ lognormal distribution in modeling the prices/
returns. But how accurate is this assumption? Are there any ways to test for this
accuracy? One way to test the validity of the normality assumption is to use normal
probability plot.

The normal probability plot is a graphical technique for normality testing which
assesses whether or not a data set is approximately normally distributed.
We first rank the data, say x1 < x2 <....<xn (i.e. xi is the ith ranked value). Then the data
are plotted against a theoretical normal distribution (i.e. we generate the corresponding
y-values, y1 < y 2 <....< yn such that Y~N(,2)) in such a way that the points should
form an approximate straight line. Departures from this straight line indicate departures
from normality. We can also plot two lines: (1) X versus Z and (2) Y versus Z. Since
Y~N(,2) and Z~N(0,1), the second one is a straight line. Again, it indicates
departures from normality if the first line departs from the second one.

Example 5(E) Based on the closing prices of Hong Kong Stock Exchange (0388) in
2015, construct two normal probability plots to assess, by visual inspection, whether
the returns are normally distributed.