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Zvi Wiener
Following P. Jorion, Financial Risk Manager Handbook
http://pluto.huji.ac.il/~mswiener/zvi.html FRM
972-2-588-3049
Risk Factors
There are many bonds, stocks and currencies. The idea is to choose a small set of relevant economic factors and to map everything on these factors.
Exchange rates Interest rates (for each maturity and indexation) Spreads Stock indices
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Historical Simulations
Fix current portfolio. Pretend that market changes are
similar to those observed in the past.
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Example
Assume we have $1 and our main currency is SHEKEL. Today $1=4.30. Historical data: 4.00 4.20 4.20 4.10 4.15
Ch. 17, Handbook
today
100 200 300 20 2 3 4 1 0.06 (1 0.061) (1 0.062) (1 0.063) 120 100 20 30 2 3 1 0.1 (1 0.11) (1 0.12) (1 0.13) 4
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today
100 200 300 20 2 3 4 1 0.06 (1 0.061) (1 0.062) (1 0.063) 120 100 20 30 2 3 1 0.1 (1 0.11) (1 0.12) (1 0.13) 4
Changes in IR
USD: NIS:
+1% -1%
+1% -1%
100 200 300 20 2 3 1 0.07 (1 0.071) (1 0.072) (1 0.073) 4 120 100 20 30 2 3 1 0.11 (1 0.11) (1 0.11) (1 0.12) 4
Ch. 17, Handbook Zvi Wiener slide 8
Returns
year
1% of worst cases
Ch. 17, Handbook Zvi Wiener slide 9
VaR
1 0.8 0.6 0.4 VaR1% 0.2
1%
Profit/Loss
-3 -2 -1 1 2 3
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Variance Covariance
Means and covariances of market factors Mean and standard deviation of the portfolio Delta or Delta-Gamma approximation VaR1%= QP 2.33 WP Based on the normality assumption!
Ch. 17, Handbook Zvi Wiener slide 11
1% 2.33W Q-2.33W
Ch. 17, Handbook
Q
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Monte Carlo
1
0.5
-1
-0.5 -0.5
0.5
-1
Ch. 17, Handbook Zvi Wiener slide 13
Monte Carlo
Distribution of market factors Simulation of a large number of events P&L for each scenario Order the results VaR = lowest quantile
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10 -5 -10 -15
20
30
40
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Weights
Since old observations can be less relevant, there is a technique that assigns decreasing weights to older observations. Typically the decrease is exponential. See RiskMetrics Technical Document for details.
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Stock Portfolio
Single risk factor or multiple factors Degree of diversification Tracking error Rare events
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Bond Portfolio
Duration Convexity Partial duration Key rate duration OAS, OAD Principal component analysis
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Credit Portfolio
rating, scoring credit derivatives reinsurance probability of default recovery ratio
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Reporting
Division of VaR by business units, areas of activity, counterparty, currency. Performance measurement - RAROC (Risk Adjusted Return On Capital).
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Backtesting
Verification of Risk Management models. Comparison if the models forecast VaR with the actual outcome - P&L. Exception occurs when actual loss exceeds VaR. After exception - explanation and action.
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Backtesting
Green zone - up to 4 exceptions Yellow zone - 5-9 exceptions Red zone - 10 exceptions or more OK increasing k intervention
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Stress
Designed to estimate potential losses in abnormal markets. Extreme events Fat tails Central questions: How much we can lose in a certain scenario? What event could cause a big loss?
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Local Valuation
Worst dP ! ( D * P) v (Worst dy )
Simple approach based on linear approximation.
Full Valuation
Worst dP ! P( y0 Worst dy ) P ( y0 )
Requires repricing of assets.
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Delta-Gamma Method
dP 1d P 2 dP } dy (dy ) 2 dy 2 dy
2
The valuation is still local (the bond is priced only at current rates).
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FRM-97, Question 13
An institution has a fixed income desk and an exotic options desk. Four risk reports were produced, each with a different methodology. With all four methodologies readily available, which of the following would you use to allocate capital? A. Simulation applied to both desks. B. Delta-Normal applied to both desks. C. Delta-Gamma for the exotic options desk and the delta-normal for the fixed income desk. D. Delta-Gamma applied to both desks.
Ch. 17, Handbook Zvi Wiener slide 27
FRM-97, Question 13
An institution has a fixed income desk and an exotic options desk. Four risk reports were produced, each with a different methodology. With all four methodologies readily available, which of the following would you use to allocate capital? A. Simulation applied to both desks. B. Delta-Normal applied to both desks. C. Delta-Gamma for the exotic options desk and the delta-normal for the fixed income desk. D. Delta-Gamma applied to both desks.
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Mapping
Replacing the instruments in the portfolio by positions in a limited number of risk factors. Then these positions are aggregated in a portfolio.
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Delta-Normal method
Assumes
W (returns) ! x ;x
Forecast of the covariance matrix for the horizon
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Delta-normal Valuation linear Distribution normal Extreme events low prob. Ease of comput. Yes Communicability Easy VaR precision Bad Major pitalls nonlinearity fat tails
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FRM-97, Question 12
Delta-Normal, Historical-Simulations, and MC are various methods available to compute VaR. If underlying returns are normally distributed, then the: A. DN VaR will be identical to HS VaR. B. DN VaR will be identical to MC VaR. C. MC VaR will approach DN VaR as the number of simulations increases. D. MC VaR will be identical to HS VaR.
Ch. 17, Handbook Zvi Wiener slide 32
FRM-97, Question 12
Delta-Normal, Historical-Simulations, and MC are various methods available to compute VaR. If underlying returns are normally distributed, then the: A. DN VaR will be identical to HS VaR. B. DN VaR will be identical to MC VaR. C. MC VaR will approach DN VaR as the number of simulations increases. D. MC VaR will be identical to HS VaR.
Ch. 17, Handbook Zvi Wiener slide 33
FRM-98, Question 6
Which VaR methodology is least effective for measuring options risks? A. Variance-covariance approach. B. Delta-Gamma. C. Historical Simulations. D. Monte Carlo.
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FRM-98, Question 6
Which VaR methodology is least effective for measuring options risks? A. Variance-covariance approach. B. Delta-Gamma. C. Historical Simulations. D. Monte Carlo.
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! W W 2 VW AW B
2 2
2 A
2 B
2 AB
2 A B
! 600
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Example
On Dec 31, 1998 we have a forward contract to buy 10M GBP in exchange for delivering $16.5M in 3 months. St - current spot price of GBP in USD Ft - current forward price K - purchase price set in contract ft - current value of the contract rt - USD risk-free rate, rt* - GBP risk-free rate X - time to maturity
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dS dP * dP df ! SP SP * KP S P P
*
The forward contract is equivalent to a long position of SP* on the spot rate a long position of SP* in the foreign bill a short position of KP in the domestic bill
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