Value at Risk (VaR)

Ch. 20, John C Hull, p.461-469

Value at Risk (VaR)

VaR is a concept that attempts to
answer the question:
What is
the potential loss in value of a risky
asset that can occur over a
specified period of time?
VaR focuses on the downside
impact of risks and the possible
losses particularly arising out of
disastrous developments in the risk
factors that have a low probability

VaR: Concept
VaR is a quantity that indicates the potential
loss in value of an asset or a portfolio of assets
that can occur over a specified period of time
with a given probability (confidence level)
VaR can be used to measure the risk exposure
of an asset, a portfolio of assets or a firm itself.
Generally used by banks & financial services
companies to assess the potential loss in value
of their business assets & firm value due to
adverse changes in market risk factors over a
specified time period.

VaR: Concept
This potential loss is compared with
their available capital & cash reserves in
order to assess whether the losses can
be covered without endangering the
survival of the firm
It has three fundamental components: a
specified level of loss in value (the VaR),
a confidence interval (probability) and a
specified period of time over which risk
is assessed

VaR: Concept
In its most common uses VaR is
computed on the basis of the
market risk factors such as interest
rate risk, stock market volatility and
economic factors
However the definition of risk can
be expanded or contracted to
compute VaR for specific purposes

VaR: Concept

VaR Statement:
The N-day X% VaR is V
Meaning of VaR Statement:
There is X percent probability that
the loss in asset value in the next
N days will NOT exceed amount
V

VaR: Concept
Meaning of VaR Statement:
V is the VaR of the asset
It is a function of two parameters: Time
horizon N days & Confidence level (X%)
It is the loss level during an N day
period that has a probability of (100 X)
% of being exceeded
Bank regulations require: N = 10 , X =
99

VaR: Concept
Que: Explain the VaR statement:
The 7-day 95% VaR of a portfolio is
Rs. 100 m.

VaR: Concept
Que: Explain the VaR statement:
The 7-day 95% VaR of a portfolio is Rs.
100 m.
Ans: There is 95% probability that over a
7-day period the loss in value of the
asset will not exceed Rs. 100m.
Equivalently: There is 5% probability that
over a 7-day period the loss in value of
the asset will exceed 100m

Calculating VaR: Basis

Distribution of Change in Portfolio Value:
Distribution of change in portfolio value
over next N days is constructed (+ve
changes in portfolio value are profits;
-ve changes are losses)
For a confidence level (probability) of X
%,
N-Day VaR is the change in
portfolio value (loss) that corresponds to
(100 X)th percentile of the distribution
of Change in portfolio value over the
next N days.

Calculating VaR: Issues

Volatility is generally expressed in
terms of percentage change in value of
asset per annum (SD of returns for 1
year period)
For an N-Day VaR volatility has to be
expressed in terms of change in value
for an N-Day period (SD of change in
value for an N-Day period )
N - day
VaR 1 - Day VaR N
Important
relation:

Calculating Daily Volatility

For calculating VaR annual volatility
(Y )has to be converted to daily
volatility (D ). Let n be the effective
no. of business days Yin a year.
D

Typically: n = 252

VaR: Estimation Approaches

1. Historical Simulation
2. Monte Carlo
Simulation
3. Model Building

1. Historical Simulation Approach

Historical data is collected on changes in
market variables that affect portfolio
value
The longer the history the greater the no.
of possibilities or scenarios for the
forecast period
For the forecast period change in portfolio
value is calculated for all possible
scenarios in the historical data
For a VaR of X confidence level (100
X)th percentile data point is the estimate

2. Monte Carlo Simulation

A stochastic process for the financial
variables is specified
Price changes of all the underlying
variables are simulated
In each simulation run change in
portfolio value is estimated
Many simulations are run to get a
reasonably large distribution of changes
in portfolio value
This distribution is used to calculate VaR

3. Model Building Approach

Assumes that individual asset
returns are normally distributed
with expected value zero & known
S.D.
Portfolio value is a linear
combination of asset returns;
hence normally distributed
Forecasts of volatility &
correlations among asset returns

Steps in Calculating VaR

1. Convert volatility per annum to volatility
per day (in percentage terms)
2. Convert volatility per day in percentage
terms to volatility per day in value terms
3. Calculate 1-Day VaR using the relevant
confidence interval (probability)
4. Convert 1-Day VaR to N-Day VaR using the
relationship specified earlier

3. Model Building Approach

Single Asset Case

2-Asset Case
Linear Model

3. Model Building Approach

Single Asset Case:

Eg: p467/Hull
2-Asset Case:
Eg: p468/Hull
Linear Model: p469/Hull