Market Risks

Market Risk Modeling

The risk of losses resulting from

unexpected changes in market factors

Interest rate risk (trading & banking book)

Equity price risk

FX risk

Commodity price risk

Market Risks

Value at Risk (VaR)

Increasingly important because of:

Securitization

Diffusion of mark-to- market approaches

Huge losses (LTCM, Barings, 2008 crisis, etc.)

Basel Capital requirements

VaR is the maximum amount that can be

lost in a given period of time with a given
level of confidence
We are X percent certain that we will not
lose more than V rupees in time T

Standard Normal Distribution

0.4
0.35
0.3
0.25

2.33sd

0.2
0.15

99%

0.1
0.05

2.4

2.85

1.5

1.95

0
-3

The simplest assumption is that daily gains /

losses are normally distributed

-2.55

0.6

VaR = s N-1(X)

Normal distribution

1.05

We are X percent certain that we will not lose

more than V rupees in the next N days

As a tool, VaR is very useful for comparing a

portfolio with the market portfolio.

-0.3

0.15

Value at Risk (VaR)

VaR can measure the risk of many types of

financial securities (i.e., stocks, bonds,
commodities, foreign exchange, off-balancesheet derivatives such as futures, forwards,
swaps, and options, and etc.)

-1.2

-0.75

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.

-1.65

Value at Risk (VaR)

-2.1

Value at Risk (VaR)

99% of the distribution lies to the right of a point 2.33 standard deviations to the left
of the mean

Example of VaR
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Suppose that daily change in the value of a

portfolio is normal and a standard deviation of
1.50%. What is the one day 99% VaR? What is
the 10-day 99% VaR?

1-day VaR = 1.5*2.33 = 3.5% of investment

10-day VaR = 1.5*sqrt(10)*2.33 = 11.05% of

investment

VaR and Regulatory Capital

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Regulators base the capital they require banks

to keep on VaR

The market-risk capital is k times the 10-day

99% VaR where k is at least 3.0

Under Basel II, capital for credit risk and

operational risk is based on a one-year 99.9%
VaR

VaR: The Time Horizon

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It is then easy to calculate VaR from the

standard deviation (1-day VaR=2.33s)

The N-day VaR equals

VaR

Regulators allow banks to calculate the 10 day

VaR as
10 times the one-day VaR

times the one-day

N-day VaR = 1-day VaR *

VaR Models
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Para-metric (Var-Covar) Approach

Historical Simulations Approach
Monte Carlo Simulation Approach

The Var-Covar Approach

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The main alternative to historical simulation is to

make assumptions about the probability
distributions of the returns on the market
variables and calculate the probability
distribution of the change in the value of the
portfolio analytically

This is known as the para-metric approach or

the variance-covariance approach

Market Risk VaR: VarCovar Approach

Microsoft Example
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Long position worth $10 million in

Microsoft shares
The volatility of Microsoft is 2.0% per day
(about 32% per year)
What is 10-day VaR at 99% confidence
level?

Microsoft Example continued

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The standard deviation of the change in

the portfolio in 1 day is $200,000
The standard deviation of the change in 10
days is

200 ,000 1 0 = $632,456

Microsoft Example continued

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We assume that the change in the value of

the portfolio is normally distributed
Since N(2.33)=0.01, the VaR is

2.33 632,456 = $1,473,621

AT&T Example

Consider a position of $5 million in AT&T

The daily volatility of AT&T is 1% (approx
16% per year)
The SD per 10 days is

50000
,
10 = $158,144
The VaR is

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158114
, 233
. = $368,405

Portfolio
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Now consider a portfolio consisting of both

Microsoft and AT&T
Suppose that the correlation between the
returns is 0.3

S.D. of Portfolio
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A standard result in statistics states that

X +Y =

2X + 2Y + 2 X Y

In this case X = 200,000 and Y = 50,000

and = 0.3. The standard deviation of the
change in the portfolio value in one day is
therefore 220,227

VaR for Portfolio

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The 10-day 99% VaR for the portfolio is

The benefits of diversification are

Exponentially Weighted Volatility

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Let weights assigned to observations decline

exponentially as we go back in time

220,227 10 2. 33 = $ 1,622 , 657

i 1

(1,473,621+368,405)1,622,657=$219,369
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(1 )
1 n

Estimate volatility or variance as

t =1

Historical Simulation
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Collect data on the daily movements in all

market variables.
The first simulation trial assumes that the
percentage changes in all market variables are
as on the first day
The second simulation trial assumes that the
percentage changes in all market variables are
as on the second day
and so on

i 1 (1 )
R t2
1 n

Historical Simulation
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Simple Historical Simulation

Weighted Historical Simulation

Historical Simulation

Historical Simulation: Stressed VaR

Suppose we use n days of historical data with

today being day n

Usual VaR calculated for 1 year 4 years

period for reporting

Let vi be the value of a variable on day i

There are n-1 simulation trials

As per Basel 2.5, calculate VaR on a 250-day

period of stressed market conditions

The ith trial assumes that the value of the

market variable tomorrow (i.e., on day n+1) is

Capital charge under market risks

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vn

vi
vi 1

Historical Simulation (Weighted)

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Let weights assigned to observations decline

exponentially as we go back in time

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Before Basel 2.5: Max(VaRt-1, mc * VaRavg)

After Basel 2.5: Max(VaRt-1, mc * VaRavg)+ Max(sVaRt1, ms * VaRavg )

Monte Carlo Simulation

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Stock prices follow a geometric Brownian

motion

i 1

(1 )
1 n

Rank observations from worst to best

Starting at worst observation sum weights until
the required quantile is reached
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The Lognormal Property

The Stock Price Assumption

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Consider a stock whose price is S

In a short period of time of length t,

the return on the stock is normally
distributed:

S
t , 2 t
S

It follows from this assumption that

2
ln S T ln S 0
T , 2T
2

or

2
T , 2T
ln S T ln S 0 +
2

where is expected return and is

volatility

Since the logarithm of S T is normal,

S T is lognormally distributed

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and -

Model Building vs Historical

Simulation

2 /2

Suppose we have daily data for a

period of several months
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is the average of the returns in each day [=E(S/S)]

- 2/2 is the expected return over the whole period
covered by the data measured with continuous
compounding (or daily compounding, which is almost
the same)
v t is the standard deviation
Ln(St+t /St ) = (- 2/2) + v t

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Thank You!!!