Value at Risk

Concepts, data, industry estimates

Adam Hoppes
Moses Chao
Portfolio applications
Cathy Li
Muthu Ramanujam
Comparison to volatility and beta
John Summers
Wei-Hao Tseng


Value at Risk:


The objective of this presentation is to introduce an
alternative way of looking at risk.
Data Description:
Monthly returns from 1970 to 2001 were collected on the following
industries and the total market(NYMEX, AMEX, NASDAQ).

Industries: SIC Codes:
Households (2047-3995)
Chip Manufactures (3622-3812)
Transportation (4000-4789)
Oil (1399-2999)
Source: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/

Each company is assigned to an industry portfolio based on their SIC
code. Value weighted monthly returns are used for the analysis.

Description of Value at Risk:
Definition:
Value at Risk is an estimate of the worst possible loss an
investment could realize over a given time horizon, under normal
market conditions (defined by a given level of confidence).

To estimate Value at Risk a confidence level must be specified.

5%
95%
Choice of confidence level 95%
Normal market conditions the returns that account for
95% of the distribution of possible outcomes.
Abnormal market conditions the returns that account for
the other 5% of the possible outcomes.

Investment returns
If a 95% confidence level is used to estimate
Value at Risk for a monthly horizon;

losses greater than the Value at Risk estimate
are expected to occur one in twenty months
(5%).
Illustrate Value at Risk:
Step 1: Transform simple monthly stock returns into continuously
compounded stock returns.
Note: Technically, log stock returns are more likely to be normally distributed.
Step 2: Choose a level of confidence.
90%, 95%, 99%, etc.
Banks are required to report Value at Risk estimated with a 99%
level of confidence to determine regulatory capital requirements.
Step 3: Compute Value at Risk from sample estimates of and .
For example, the largest likely loss in the household industry over
the next month under normal market conditions with a 95% level
of confidence is: $18,000.
Note: It is possible to realize a loss greater than $18,000.
Other Common Interpretations of
Value at Risk:

an attempt to provide a single number for senior management
summarizing the total risk in a portfolio of assets
Hull, OF&OD

an estimate, with a given degree of confidence, of how much one can
lose from ones portfolio over a given time horizon
Wilmott, PWOQF
Conclusions:

Value at Risk can be used as a stand alone risk measure or be applied
to a portfolio of assets.

Value at Risk is a dollar value risk measure, as opposed to the other
measurements of risk in the financial industry such as: beta and
standard deviation.

We are X percent certain that we will not lose more than V dollars in
the next N days. Hull

Value at Risk:
r*
0
ValueAtRisk V (1 e )

r* 1.645*


Household Oil Chips Trans Market
= 0.0091 0.0101 0.0089 0.0081 0.0094
= 0.0512 0.0542 0.0801 0.063 0.0465
VAR = $18,101 $19,024 $28,891 $22,769 $16,223
Value at Risk estimates for monthly horizon
using 95% confidence level December 31,
2001, V
0
= $250,000

Stand-alone estimates of Value at risk for each investment.
Value at Risk
Part
Value at Risk(Portfolio)
One month
Parametric method-normal distribution
Current market value of portfolio $1M
Confidence level 95%
Portfolio
Equally weighted portfolio; household,
chips, transportation and oil.
Sample used to estimate variance-
covaraince matrix.
Rp=W1R1+W2R2+W3R3+W4R4

p
=Wi i+i,jWiWjij
VAR=V0*(1-exp(r
*
))
Variance & Covariance
Var-Covar Hshld Chips Trans oil
Hshld 0.0026 0.0026 0.0022 0.0013
Chips 0.0026 0.0064 0.0034 0.0019
Trans 0.0022 0.0034 0.0040 0.0018
Oil 0.0013 0.0019 0.0018 0.0029
Correlation
Correlation Hshld Chips Trans Oil
Hshld 1 0.6313 0.6974 0.4556
Chips 0.6313 1 0.6842 0.4350
Trans 0.6974 0.6842 1 0.5177
Oil 0.4556 0.4350 0.5177 1
Portfolio benefits
Value At Risk for the portfolio - $72,750
Sum of stand-alone Value at Risks - 88,784
Benefits due to diversification $16,034
Marginal and Component Value at Risk
Household Chips Transportation Oil
Marginal Value
At Risk $0.07 $0.11 $0.09 $0.06
Component
Value At Risk $17,411 $28,628 $22,834 $15,705
Value at Risk
Part I
Measures of Risk
Standard Deviation ()
Beta ()
Value at Risk (VaR)


Measured by
VAR
Measured by




Stand-Alone Risk
Or
Total Risk



Systematic
Risk



Unsystematic
Risk



Non-
Diversifiable
Risk



Diversifiable
Risk



Market Risk





Company-
Specific Risk


Dispersion of Returns
Variances and Standard Deviations
Variance (
2
) Formula:



Variance and Standard Deviation are measures of
total (or stand-alone) risk.
The larger the variance (or Std. Dev.), the lower
the probability that actual returns will be close to
the expected return.



2
1
2
) (

k k
n
i
i

Risk Measure - Beta ()

Beta () formula:


Beta measures the portfolios systematic risk, that
is, the degree to which its return is correlated with
the return on the market as a whole.
Stock with high beta (>1) is more volatile than
the market taken as a whole.
) (
) , (
m
m i
k Var
k k Cov

Risk Measures Value at Risk (VaR)
VaR is a measure of risk based on a
probability of loss and a specific time
horizon.
VaR translates portfolio volatility into a
dollar value.
Measure of Total Risk) rather than
Systematic (or Non-Diversifiable Risk)
measured by Beta.

Advantages of VaR
VaR provides an measure of total risk.
VaR is an easy number to understand and explain
to clients.
VaR translates portfolio volatility into a dollar
value.
VaR is useful for monitoring and controlling risk
within the portfolio.


Advantages of VaR (Cont.)
VaR can measure the risk of many types of
financial securities (i.e., stocks, bonds,
commodities, foreign exchange, off-balance-sheet
derivatives such as futures, forwards, swaps, and
options, and etc.)
As a tool, VaR is very useful for comparing a
portfolio with the market portfolio (S&P500).

VaR vs. Traditional Risks
Risk measures for four industries:
(Note: One-month VaR with 95% confidence level, mean monthly
return and standard deviation of return calculated using monthly
observations from 1970- 2001, N = 384.)
Monthly Hshld Oil Chips Trans Mkt
Std. Dev. 5.12% 5.42% 8.01% 6.30% 4.65%
Beta 0.94 0.78 1.42 1.12 1.00
VaR (%) -7.52% -7.91% -12.28% -9.55% -6.71%
VaR ($) $18,100.83 $19,024.02 $28,890.92 $22,768.71 $16,223.08
Industries vs. Market
Relative VaR
Relative VaR measures the risk of
underperformance relative to a pre-defined
benchmark.
Relative VaR is calculated from a time series of
the difference in monthly logarithmic returns of an
investment minus the logarithmic return of the
benchmark portfolio.
Relative VaR (Cont.)









Note: One-month VaR and Relative VaR with 95% confidence level,
mean monthly return and standard deviation of return calculated using
monthly observations from 1970- 2001, N = 384.


Monthly Hshld Oil Chips Trans Mkt
Average 0.91% 1.01% 0.89% 0.81% 0.94%
Std. Dev. 5.12% 5.42% 8.01% 6.30% 4.65%
VaR (%) -7.52% -7.91% -12.28% -9.55% -6.71%
VaR ($) $18,100.83 $19,024.02 $28,890.92 $22,768.71 $16,223.08
Monthly Rel_Hshld Rel_Oil Rel_Chips Rel_Trans Mkt
Average -0.04% 0.07% -0.05% -0.13% -
Std. Dev. 2.69% 4.17% 4.90% 3.59% -
Relative VaR (%) -4.47% -6.79% -8.11% -6.04% -
Relative VaR ($) $10,917.36 $16,417.18 $19,471.36 $14,646.77 -