FRM

VaR
Zvi Wiener
02-588-3049
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
VaR by example
Zvi Wiener VaR example slide 2
Assets
NIS TSAMUD $ Yen
Deposit 1yr. 6% 4,000
Bonds 10yr. 5% 2,000
Credit 3yr. 15% 8,000
Liabilities
NIS TSAMUD $ Yen
Saving 2yr. 4% 1,800
Deposit 1mo. 11% 8,200
Deposit 3mo. L-2% 3,000
Total: (200) 200 4,000 (3,000)
Today L=6%
Zvi Wiener VaR example slide 3
Risk Factors
USD/NIS exchange rate
Yen/NIS exchange rate
Inflation
Real NIS interest rates (IR, 10 yr., 2 yr.)
Nominal NIS IR (1mo., 10 yr.)
USD IR, (1 yr.)
Yen IR, (Libor 3 mo.)
Zvi Wiener VaR example slide 4
Fair Value
For risk measurement we need not only the
fair value, but the fair value as a function of
risk factors in order to estimate the potential
profit/loss.
3000 1800 8200 4000 2000 8000 + +
Zvi Wiener VaR example slide 5
Fair Value Function
3 1
3 ,
3 0
3 ,
1
0
) 1 (
) 1 (
8000
y NIS
y NIS
r
r
M
M
+
+
10 1
10 ,
10 0
10 ,
) 1 (
) 1 (
2000
y real
y real
r
r
+
+
1
1 $,
0
1 $,
1
0
0
1
1
1
4000
y
y
r
r
M
M
d
d
+
+
Zvi Wiener VaR example slide 6
Fair Value Function
|
|
.
|

\
|
+
|
|
.
|

\
|
+
12
1
12
1
8200
1
1 ,
0
1 ,
1
0
mo NIS
mo NIS
r
r
M
M
Zvi Wiener VaR example slide 7
Fair Value Function
2 1
2 ,
2 0
2 ,
) 1 (
) 1 (
1800
y real
y real
r
r
+
+
) 02 . 0 ( 25 . 0 1
) 02 . 0 ( 25 . 0 1
3000
1
1 ,
0
1 ,
1
0
0
1
+
+
y Y
y Y
L
L
M
M
Y
Y
Zvi Wiener VaR example slide 8
Sensitivity
CPI
USD
Yen
r
nominal
1mo
r
nominal
3yr
r
real
2yr
r
real
10yr
r
USD
1yr
r
Yen
3mo
0.1%
1%
2%
0.5%
0.5%
0.5%
0.5%
0.25%
0.25%
-8
40
-60
3
-103
17
-93
-10
2
Biggest market risk
Significant risk
Significant risk
Zvi Wiener VaR example slide 9
Risky Scenario
2yr 10 yr T
Real r
Zvi Wiener VaR example slide 10
Sensitivity
CPI
USD
Yen
r
nominal
1mo
r
nominal
3yr
r
real
2yr
r
real
10yr
r
USD
1yr
r
Yen
3mo
0.1%
1%
2%
0.5%
0.5%
0.5%
0.5%
0.25%
0.25%
-8
40
-60
3
-103
17
-93
-10
2
Are not included
into BoI
requirements
Zvi Wiener VaR example slide 11
Gradient Vector
Direction of fastest decay (loss).
Take the sensitivity vector and divide it by the
assumed changes in the risk factors.
o
o
o
) ( ) (
lim ) ( '
0
x f x f
x f
+
=

o
o ) ( ) (
) ( '
x V x V
x V
+
~
Zvi Wiener VaR example slide 12
What if ...
The sensitivity vector allows to estimate
quickly an impact of a certain market move on
the value of the portfolio.
Scalar multiplication of the gradient vector
and the hypothetical market change vector
gives the predicted loss/gain.
Zvi Wiener VaR example slide 13
Risk Measurement
The gradient vector describes my exposure
to risk factors
The distribution of risk factors allows me to
estimate the potential loss together with
probability of such an event.
The stress test will describe the response to
specific (the most interesting) scenarios.
Zvi Wiener VaR example slide 14
Risk Management
Swap Dollar Yen
Two forward contracts
Quanto option
FRA (?)
Fixed - floating swap
Zvi Wiener VaR example slide 15
Duration and IR sensitivity
Zvi Wiener VaR example slide 16
The Yield to Maturity
The yield to maturity of a fixed coupon
bond y is given by

=

=
n
i
y t T
i
i
e c t p
1
) (
) (
Zvi Wiener VaR example slide 17
Macaulay Duration
Definition of duration, assuming t=0.
p
e c T
D
n
i
y T
i i
i

=
1
Zvi Wiener VaR example slide 18
Macaulay Duration
What is the duration of a zero coupon bond?

= =
+
= =
T
t
t
t
T
t
t
y
CF
t
ice Bond
w t D
1 1
) 1 ( Pr
1
A weighted sum of times to maturities of each
coupon.
Zvi Wiener VaR example slide 19
Meaning of Duration
Dp e c
dy
d
dy
dp
n
i
y T
i
i
=
)
`

=

=

1
r
$
Zvi Wiener VaR example slide 20
Proposition 15.12 TS of IR
With a term structure of IR (note y
i
), the
duration can be expressed as:
Dp e c
ds
d
s
n
i
s y T
i
i i
=
)
`

=
=
+

0
1
) (
p
e c T
D
n
i
y T
i i
i i

=
1
Zvi Wiener VaR example slide 21
Convexity
r
$
2
2
y
p
C
c
c
=
Zvi Wiener VaR example slide 22
FRA Forward Rate Agreement
A contract entered at t=0, where the parties (a
lender and a borrower) agree to let a certain
interest rate R*, act on a prespecified principal,
K, over some future time period [S,T].
Assuming continuous compounding we have
at time S: -K
at time T: Ke
R*(T-S)

Calculate the FRA rate R* which makes PV=0
hint: it is equal to forward rate
Zvi Wiener VaR example slide 23
Exercise 15.7
Consider a consol bond, i.e. a bond which
will forever pay one unit of cash at t=1,2,
Suppose that the market yield is y - flat.
Calculate the price of consol.
Find its duration.
Find an analytical formula for duration.
Compute the convexity of the consol.
Zvi Wiener VaR example slide 24
ALM Duration
Does NOT work!
Wrong units of measurement
Division by a small number
r
A
A
D
A
c
c
=
1
r
L
L
D
L
c
c
=
1
r
L A
L A
D
L A
c
c

) ( 1
Zvi Wiener VaR example slide 25
ALM Duration
A similar problem with measuring yield
r
P
VaR
P
c
c 1