Value at Risk

By A.V. Vedpuriswar

September 17, 2016

Acknowledgement
This presentation draws heavily from the work of Prof John C
Hull, an authority on Risk management.

Introduction
VAR tells us the maximum loss a portfolio may suffer at a
given confidence interval for a specified time horizon.
If we are 95% sure that the portfolio will not suffer more than $
10 million in a day, we say the 95% daily VAR is $ 10 million.

Computing Value at Risk

VaR is the product of :
Value of portfolio

Z factor ( depends on confidence level)

Volatility
Time ( VaR scales in proportion to square root of time)

Calculating Value at Risk

The usual practice is to calculate daily volatility by observing the
daily opening and closing prices of the portfolio over a period of
time, say 6 months.
Then we obtain the volatility for the actual period under
consideration by multiplying by the square root of the time.
Thus the volatility for 5 trading days will be that for one day
multiplied by 5.

UBS: Management Value at Risk

UBS: Regulatory Value at Risk

UBS: Stressed Value at Risk

Problem
Average revenue = $5.1 million per day
Total no. of observations = 254. Std dev = $9.2 million

Confidence level = 95%

No. of observations < - $10 million = 11

No. of observations < - $ 9 million = 15

Find 95% VAR.
Solution

The point such that the no. of observations to the left = (254) (.05) = 12.7
(12.7 11) /( 15 11 )

So required point = - (10 - .4 x 1)

VAR = E (W) (-9.6)

.4

1.7 / 4
=

- $9.6 million

= 5.1 (-9.6) = $14.7 million

If we assume a normal distribution,

Z at 95% ( one tailed) confidence interval = 1.645
VAR = (1.645) (9.2)

$ 15.2 million

Problem
The VAR on a portfolio using a one day time horizon is USD
100 million. What is the VAR using a 10 day horizon ?

Solution
Variance scales in proportion to time.
So variance gets multiplied by 10

And std deviation by 10

VAR = 100 10 = (100) (3.16)

316

(N2 = 12 + 22 .. = N2)
Note; This approach is valid only when the daily variances are
independent.
9

Problem

If the daily VAR is $12,500, calculate the weekly, monthly, semi

annual and annual VAR. Assume 250 days and 50 weeks per
year.
Solution
Weekly VAR

(12,500) (5)
27,951

Monthly VAR

( 12,500) (20)
55,902

Semi annual VAR

(12,500) (125)
139,754

Annual VAR

(12,500) (250)
197,642
10

Variance Covariance Method

11

Problem
Consider a position consisting of a $100,000 investment in asset A and a $100,000
investment in asset B. Assume that the daily volatilities of both assets are 1% and
that the coefficient of correlation between their returns is 0.3. What is the 5-day
99% VaR for the portfolio?

Solution
The standard deviation of the daily change in the investment in each asset is
$1,000. The variance of the portfolios daily change is
1,0002 + 1,0002 + 2 x 0.3 x 1,000 x 1,000 = 2,600,000
The standard deviation of the portfolios daily change is $1,612.45.

The standard deviation of the 5-day change is

1,612.45 x 5 = $3,605.55
From the tables of N(x) we see that Z = 2.33.

The 5-day 99 percent value at risk is therefore 2.33 x 3,605.55 = $8,401.

Ref : John C Hull, Options, Futures and Other Derivatives

14

Problem

We have a portfolio of $10 million in shares of Microsoft. We want

to calculate VAR at 99% confidence interval over a 10 day horizon.
The volatility of Microsoft is 2% per day.

Solution

= 2%

= (.02) (10,000,000)

= $200,000

Z (p = .01)

= Z (p =.99)

= 2.33

Daily VAR

= (2.33) (200,000)

= $ 466,000

10 day VAR

= 466,000 10

= $ 1,473,621

Ref : John C Hull, Options, Futures and Other Derivatives

15

Problem
Consider a portfolio of $5 million in AT&T shares with a daily
volatility of 1%. Calculate the 99% VAR for 10 day horizon.

Solution
= 1%

(.01) (5,000,000)

= $ 50,000

Daily VAR

(2.33) (50,000)

= $ 116,500

$ 116,500 10

= $ 368,405

10 day VAR =

Ref : John C Hull, Options, Futures and Other Derivatives

16

Problem

Now consider a combined portfolio of AT&T and Microsoft shares.

Assume the returns on the two shares have a bivariate normal
distribution with the correlation of 0.3. What is the portfolio VAR.?
Solution
2 = w12 12 + w22 22 + 2 w1 w2 1 2

= (200,000)2 + (50,000)2 + (2) (.3) (200,000) (50,000)

Daily VAR = (2.33) (220,277)

513,129

10 day VAR = (513,129) 10

$1,622,657

220,277

Effect of diversification = (1,473,621 + 368,406) (1,622,657)

= 219,369
17

Ref : John C Hull, Options, Futures and Other Derivatives

Problem
Consider a portfolio made up of 5 year 5 % coupon government
bonds. The bonds are trading at $ 100. The historical annual
volatility is 1 %. Expected YTMs are normally distributed with zero
mean and volatility of 1%. Calculate the 95% one year VAR.

Solution
Worst YTM = actual YTM + 1.65 x Volatility
= 5 + 1.65 x 1 = 6.65%

If YTM is 6.65%, bond price will be 93.1708

So the VAR is 100-93.17 = $ 6.83

18

Problem
Consider the following single bond of $10 million, a modified
duration of 3.6 yrs and annualized yield volatility of 2%.
Calculate the 10 day holding period VaR of the position with a 99%
confidence interval, assuming there are 252 days in a year.
Solution
VAR = $10,000,000* 0.02*3.6* 10/252 * 2.33 = $334,186

19

Problem
Assume that a risk manager wants to calculate VAR for an S&P
500 futures contract using the historical simulation approach. The
current price of the contract is 935 and the multiplier is 250. Given
the historical price data shown below for the previous 300 days,
what is the VAR of the position at 99% using the historical
simulation methodology?
Returns: -6.1%,-6%,-5.9%,-5.7%, -5.5%, -5.1%..........4.9%, 5%,
5.3%, 5.6%, 5.9%, 6%
Solution
The 99% return among 300 observations would be the 3rd worst
observation among the returns.
Among the returns given above -5.9% is the 3rd worst return, the
99% VAR for this position is therefore
(935)*250* (0.059) = $13,791.

20

Problem
Consider the portfolio of an American trader with two foreign
currencies, Canadian dollar and euro. These two currencies are
uncorrelated and have a volatility against the dollar of 5% and 12%
respectively. The portfolio has $2 million invested in CAD and $1
million in Euro. What is the portfolio VAR at 95% confidence level?

Solution
Variance of the portfolio return

= {(2 (.05)}2 + {(1) (.12)}2

=.01 + .0144 = .0244

Std devn = .0244

$ .156205 million

VAR = (1.65) (156,205)

$257,738

VAR for Canadian dollar part

= $ (1.65) (.05) (2) million
= $165,000

VAR for Euro part

=

Undiversified VAR

= $ (1.65) (.12) (1) million

$ 198,000
=

$ 363,000

Thus the diversified VAR is significantly lower.

21

Problem

Suppose we increase the Canadian dollar position by $10,000.

What is the marginal VAR?
Solution

Variance = {(2.01) (.05)}2 + {(1) (.12)}2=.0101 + .0144=

.0245

= .0245

$.1565 million

VAR

$ 258,225

Marginal VAR

(1.65) (156,500)

= 258,225 257,738

= $ 487

22

Problem
An American trader owns a portfolio of options on the US dollar-sterling exchange
rate. The delta of the portfolio is 56.0. The current exchange rate is $/ 1.5000.
Derive an approximate linear relationship between the change in the portfolio value
and the percentage change in the exchange rate. If the daily volatility of the
exchange rate is 0.7%, estimate the 10-day 99% VaR.

Solution
The approximate relationship between the daily change in the portfolio value, P,
and the daily change in the exchange rate, S, is P = 56 S
For a unit change in , $ will change by 1.5. It follows that

P = 56 x 1.5 x

Or

P = 84 x

The standard deviation of x equals the daily volatility of the exchange rate, or 0.7
percent.
The standard deviation of P is therefore 84 x 0.007 = $ 0.588.
So the 10-day 99 percent VaR for the portfolio is

0.588 x 2.33 x 10

= $ 4.33 for an investment of 1.

Ref : John C Hull, Options, Futures and Other Derivatives

23

Problem
Some time ago a company entered into a forward contract to buy 1 million for $1.5 million. The
contract now has 6 months to maturity. The daily volatility of a 6-month zero-coupon sterling

bond (when its price is translated to dollars) is 0.06% and the daily volatility of a 6-month zerocoupon dollar bond is 0.05%. The correlation between returns from the two bonds is 0.8. The

current exchange rate is $/ 1.53. Calculate the standard deviation of the change in the dollar
value of the forward contract in 1 day. What is the 10-day 99% VaR? Assume that the 6-month

interest rate in both sterling and dollar is 5% per annum with continuous compounding.

Solution
The contract is a long position in a sterling bond plus a short position in a dollar bond.

The value of the sterling bond is 1.53e -0.05x0.5 or $1.492 million.

The value of the dollar bond is 1.5e-0.05x0.5 or $1.463 million.
The variance of the change in the value of the contract in one day is :
1.4922 x 0.00062 + 1.4632 x 0.00052 2 x 0.8 x 1.492 x 0.0006 x
0.000000288

1.463 x 0.0005

The standard deviation is therefore $0.000537 million.

The 10-day 99% VaR is $0.000537 x 10 x 2.33 =
$0.00396 million
Ref : John C Hull, Options, Futures and Other Derivatives

24

Problem
Consider the contract on the dollar/euro exchange rate (EC)
traded on the CME. The notional amount is 125,000 Euros.
Assume that the annual volatility is 12% and the current price is
$1.05 per Euro. Find daily VAR at 99% confidence level.

Solution
VAR = (2.33) [(.12) / 252] (125,000 1.05)

= $ 2310

25

Problem
Consider a portfolio with a one day VAR of $1 million.
Assume that the market is trending with an auto correlation of
0.1. Under this scenario, what would you expect the two day
VAR to be?
Solution
V2

22 (1 + )

2 (1)2 (1 + .1)

2.2

2.2

1.4832

26

Auto correlation over longer periods

Consider a period of 5 days.
We assume the first days movement will have an impact on
the second day's movement through the correlation
coefficient.

The first days movement will affect the third days movement
through the square of the correlation coefficient and so on.
Then the combined variance will be:

2 + 2 + 2 + 2 + 2 + (2) () 2 + (2) ()2 2 + (2) ()3 2 +

(2) ()4 2 + (2) () 2 + (2) ()2 2 + (2) ()3 2 + (2) () 2 +
(2) ()2 2

+ (2) () 2

= 5 2 + (8) () 2 + (6) ()2 2 + (4) ()3 2 + (2) ()4 2

Problem
Consider a portfolio with standard deviation of daily returns of 0.1
and autocorrelation of 0.3. Calculate the 5 day volatility.
Solution
= 0 .1; = .3

Variance

(5) (.1)2 + (4) (2) (.3) (.1)2

+ (3) (2) (.3)2 (.1)2 + (2) (2) (.3)3 (.1)2

+ (2) (.3)4 (.1)2

.05 + .024 + .0054 + .00108 + .000162

.080642

Volatility

.284
28

Monte Carlo Simulation

29

What is Monte Carlo VAR?

The Monte Carlo approach involves generating many price
scenarios (usually thousands) to value the assets in a portfolio
over a range of possible market conditions.
The portfolio is then revalued using all of these price scenarios.

Finally, the portfolio revaluations are ranked to select the

required level of confidence for the VAR calculation.

30

Generate Scenarios
The first step is to generate all the price and rate scenarios
necessary for valuing the assets in the relevant portfolio, as
well as the required correlations between these assets.

There are a number of factors that need to be considered

when generating the expected prices/rates of the assets:
Opportunity cost of capital
Stochastic element
Probability distribution

31

Opportunity Cost of Capital

A rational investor will seek a return at least equivalent to the
risk-free rate of interest.
Therefore, asset prices generated by a Monte Carlo simulation
must incorporate the opportunity cost of capital.

32

Probability Distribution
Monte Carlo simulations are based on random draws from a
variable with the required probability distribution, usually the
normal distribution.
The normal distribution is useful when modeling market risk in
many cases.
But it is the returns on asset prices that are normally
distributed, not the asset prices themselves.

So we must be careful while specifying the distribution.

33

Calculate the Value of the Portfolio

Once we have all the relevant market price/rate scenarios, the

next step is to calculate the portfolio value for each scenario.

For an options portfolio, depending on the size of the portfolio, it

may be more efficient to use the delta approximation rather than
a full option pricing model (such as Black-Scholes) for ease of
calculation.
(Option) = (S)
Thus the change in the value of an option is the product of the
delta of the option and the change in the price of the underlying.

34

Other approximations
There are also other approximations that use delta, gamma ()
and theta () in valuing the portfolio.
By using summary statistics, such as delta and gamma, the
computational difficulties associated with a full valuation can be
reduced.

Approximations should be periodically tested against a full

revaluation for the purpose of validation.
When deciding between full or partial valuation, there is a tradeoff between the computational time and cost versus the
accuracy of the result.

The Black-Scholes valuation is the most precise, but tends to

be slower and more costly than the approximating methods.
35

Reorder the Results

After generating a large enough number of scenarios and
calculating the portfolio value for each scenario:
the results are reordered by the magnitude of the change in the
value of the portfolio (portfolio) for each scenario
the relevant VAR is then selected from the reordered list
according to the required confidence level
If 10,000 iterations are run and the VAR at the 95% confidence
level is needed, then we would expect the actual loss to exceed
the VAR in 5% of cases (500).
So the 501st worst value on the reordered list is the required
VAR.
Similarly, if 1,000 iterations are run, then the VAR at the 95%
confidence level is the 51st highest loss on the reordered list.
36

Formula used typically in Monte Carlo for stock price

modelling

37

Advantages of Monte Carlo

We can cope with the risks associated with non-linear
positions.
We can choose data sets individually for each variable.
This method is flexible enough to allow for missing data
periods to be excluded from the VAR calculation.
We can incorporate factors for which there is no actual
historical experience.
We can estimate volatilities and correlations using different
statistical techniques.

38

Problems with Monte Carlo

Cost of computing resources can be quite high.

Speed can be slow.

Random Numbers may not be all that random.
Pseudo random numbers are only a substitute for true
random numbers and tend to show clustering effects.

Monte Carlo often assumes normal distribution.

But it can be performed with alternative distributions.
Results (value at risk estimate) depend critically on the
models used to value (often complex) financial instruments.

39

Historical Simulation

40

Introduction
Unlike the Monte Carlo approach, it uses the actual historical
distribution of returns to simulate the VAR of a portfolio.

Real data plus ease of implementation, have made historical

simulation a very popular approach to estimating VAR.
Historical simulation avoids the assumption that returns on
the assets in a portfolio are normally distributed.
Instead, it uses actual historical returns on the portfolio assets
to construct a distribution of potential future portfolio losses.
This approach requires minimal analytics.
All we need is a sample of the historic returns on the portfolio
whose VAR we wish to calculate.
41

Steps
Collect data
Generate scenarios
Calculate portfolio returns
Arrange in order.

42

What is VAR (90%) ?

% Returns
- 16
- 14
- 10
-7
-5
-4
-3
-1
0
1
2
4
6
7
8
9
11
12
14
18
21
23

Frequency
1
1
1
2
1
3
1
2
3
1
2
1
1
1
1
1
1
1
2
1
1
1

Cumulative Frequency
1
2
3
5
6
9
10
12
15
16
18
19
20
21
22
23
24
26
27
28
29
30

10% of the observations, i.e, (.10) (30)

= 3 lie below -7
43

So VAR = -7

Advantages and Disadvantages of Historical simulation

Advantages

Disadvantages

Simple

Reliance on the past

No normality assumption

Length of estimation period

Non parametric

Weighting of data

44

Simulation vs Variance Covariance methods

Simulation approaches are preferred by global banks due to:
flexibility in dealing with the ever-increasing range of complex instruments
in financial markets
the advent of more efficient computational techniques in recent years

the falling costs in information technology

However, the variance-covariance approach might be the most

appropriate method for many smaller firms, particularly when:
they do not have significant options positions
they prefer to outsource the data requirement component of their risk
calculations to a company such as RiskMetrics
significant savings can often be made by using outsourced volatility and
correlation data, compared to internally storing the daily price histories
required for simulation techniques

46

Model Validation

47

Basel Committee Standards (1)

Banks that prefer to use internal models must meet, on a daily
basis, a capital requirement that is the higher of either:
the previous day's value at risk
the average of the daily value at risk of the preceding 60 business days
multiplied by a minimum factor of three

VAR must be computed on a daily basis.

A one-tailed confidence interval of 99% must be used.

The minimum holding period should be 10 trading days .

The minimum historical observation period should be one
year.

48

Basel Committee Standards(2)

Banks should update their data sets at least once every three
months.
Banks can recognize correlations within broad risk categories.
Provided the relevant supervisory authority is satisfied with the
bank's system for measuring correlations , they may also
recognize correlations across broad risk factor categories.
Banks' internal models are required to accurately capture the
unique risks associated with options and option-like instruments.
The Basel Committee has also specified qualitative factors that
banks must meet before they are permitted to use internal models.

49

Basel Committee Standards(3)

The Basel Committee prescribes an increase in capital
requirements if, based on a sample of 250 observations (a oneyear observation period), the VAR model underpredicts the
number of exceptions (losses exceeding the 99% confidence
level).

For such purposes, three 'zones' have been distinguished by the

Committee.
Green Zone :

0-4 exceptions

Yellow zone :

5-9 exceptions

Red zone

10 or more exceptions

Note: These standards may have undergone some changes

recently. I will update shortly.
50

Problem
Based on a 90% confidence level, how many exceptions in
back testing a daily VAR model should be expected over a
250 day trading year?

Solution
10% of the time loss may exceed VAR

So no. of observations = (.10) (250)

25

51

Problem
We are currently feeding a model with 600 days of data. The
VAR confidence level is 99%. Nine exceptions are observed.
Should we reject the model? Suppose it had been 12. Would
we reject the model?
Solution

1 Binomdist (8, 600, .01, True) = .152

So we cannot reject the model at 5% significance level.
1 Binomdist (11, 600, .01, True) =

.019

So we would reject the model at 5% significance level

Ref : John C Hull, Options, Futures and Other Derivatives

Problem
We back test a VAR model with 1000 days of data. The VAR
confidence level is 99%. 17 exceptions are observed. Should the
model be rejected at 5% significance level?
Solution

The probability of the VAR being exceeded on a given day

= 1 - .99

.01

The probability of the VAR being exceeded on 17 days or more

=1 Binomdist (16, 1000, .01, True) =

2.64% < 5%

So the model should be rejected.

Ref : John C Hull, Options, Futures and Other Derivatives

2.64%

Problem
A $10 million one year loan has a 1.25% probability of default. If
there is a default, the recovery can be anything from 0 to the full
loan value. Calculate the 99% VAR and conditional VAR.

Solution
Default zone = 1.25% starting from 98.75% going up to 100%.
Loss at 99% point =[ .25/1.25] X 10 = $ 2 million.
So the 99% VAR is $ 2million.

Expected shortfall = {2 + 10]/2 = $ 6 million

54

Stress Testing

55

Introduction
Stress testing involves analysing the effects of exceptional
events in the market on a portfolio's value.

These events may be exceptional, but they are also plausible.

And their impact can be severe.
Historical scenarios or hypothetical scenarios can be used.

56

Two approaches to Stress testing

Single-factor stress testing (sensitivity testing) involves
applying a shift in a specific risk factor to a portfolio in order to
assess the sensitivity of the portfolio to changes in that risk
factor.
Multiple-factor stress testing (scenario analysis) involves
applying simultaneous moves in multiple risk factors to a
portfolio to reflect a risk scenario or event that looks plausible
in the near future.

57

Extreme Value Theory

EVT is a branch of statistics dealing with the extreme deviations from the
mean of statistical distributions.
The key aspect of EVT is the extreme value theorem.
According to EVT, given certain conditions, the distribution of extreme
returns in large samples converges to a particular known form, regardless
of the initial or parent distribution of the returns.

This distribution is characterized by three parameters location, scale and

shape (tail).
The tail parameter is the most important as it gives an indication of the
heaviness (or fatness) of the tails of the distribution.
The EVT approach is very useful because the distributions from which
return observations are drawn are very often unknown.
EVT does not make strong assumptions about the shape of this unknown
distribution.
58

Gaussian Copulas
Consider variables, V1 and V2 that are not normally
distributed.
Map the two variables on to a normal distribution.

Apply correlation
Create bivariate normal distribution.

59

Illustration
Consider 2 variables that have a uniform distribution. Using
Gaussian copula, and assuming a copula correlation of 0.3,
define a correlation structure.

0.25

0.50

0.75

0.25
0.50
0.75

60

0.25

0.50

0.75

0.25

-.675, -.675

-.675, 0

-.675, +.675

0.50

0,

0.75

+.675, -.675

+.675, 0

+.675, .+ 675

0.25

0.50

0.75

0.25

.095

.1633

.2157

0.50

.1633

.2985

.4134

0.75

.2157

.4134

.5953

-.675

0, 0

0,

+ .675

61

Illustration
x

percentile

percen
tile

0.1 5.00

-1.65

2.00

-2.06

0.2 20.00

-.84

8.00

-1.41

0.3 38.75

-.29

18.00

-.92

0.4 55.00

.13

32.00

-.47

0.5 68.75

.49

50.00

0.6 80.00

.84

68.00

.47

0.7 88.75

1.21

82.00

.92

0.8 95.00

1.65

92.00

1.41

0.9 98.75

2.24

98.00

2.06

Correlation coefficient = 0.5

62

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

0.1

.006

.017

.028

.037

.044

.048

.049

.050

.050

0.2

.013

.043

.081

.120

.156

.181

.193

.198

.200

0.3

.017

.061

.124

.197

.273

.331

.364

.381

.387

0.4

.019

.071

.149

.248

.358

.449

.505

.535

.548

0.5

.019

.076

.164

.281

.417

.537

.616

.663

.683

0.6

.020

.078

.173

.301

.456

.600

.701

.763

.793

0.7

.020

.079

.177

.312

.481

.642

.760

.837

.877

0.8

.020

.080

.179

.318

.494

.667

.798

.887

.936

0.9

.020

.080

.180

.320

.499

.678

.816

.913

.970

63

VAR Cash flow mapping

Problem
Consider a long position in a $1 million Treasury bond.

Maturity

0.8 years

Coupon

10% payable semiannually

Annualised yield
Volatility

Annualized yield & volatility

3 Month
6 Month
1 Year
5.50
6.00
7.00
0.06
0.10
0.20

3 month
6 month
1 year

Correlations between daily returns

3 Month
6 Month
1 Year
1.0
0.9
0.6
0.9
1.0
0.7
0.6
0.7
1.0

Explain how mapping can be done while calculating VaR.

Ref : John C Hull, Options, Futures and Other Derivatives

Solution
The current position involves the following:
Cash flow of $50,000 in .3 years

Cash flow of $1,050,000 in .8 years

So the position can be considered a combination of two
zero coupon bonds, maturity 0.3, 0.8 years.
Let us write the position as equivalent to a combination of
standard 3 month, 6 month and 1 year bonds.
3 years = (.3) (12)

3.6 months.

3 month interest rate

5.50%

6 month interest rate

6.00%

Effective interest rate for 3.6 months zero coupon bond

= 5.50 + (.6/3)(.5) = 5.6% = .056
Present value =

Volatility

50,000
(1.056).3
.6
.06 (.04)
3

49,189

.068%.

Let us allocate to a 3 month bond and 1 - to a 6 month bond.

Then we can write:

Here = .068

12 + 22 + 2 12

= .06

2 = .10

= .90

or .0682 = 2 (.06)2+ (1-)2(.10)2 + 2 (.9)() (1-)(.06)(.10)

or .0682 = 2 (.06)2 + (1-)2 (.10)2 + 2(.9) ()(1-)(.06)(.10)
Putting = .7603,

LHS = .00462, RHS = .00208 + .00057 + .001968= .00462

So we can write the position as equivalent to
$ (.7603) (49,189)

$37,397 in 3 month bond

$ (.2397) (49,189)

$11,791 in 6 month bond

Now consider $1,050,000 received after 0.8 years.

It can be considered a combination of 6 month and 12 month

positions.
Interpolating the interest rate we

get: .06

Present value of cash flows =

1,050,000
(1.066).8

Volatility = [.1 + (3.6/6)(0.1) ]

3.6
(.01)
6

=.066
= $997,662

= 0.16

If is the position in the 6 month bond and (1-) in the 12

month bond, 2
= 2 12 + (1-)2 22 + 2 (1-) 12
Or (.16)2

= 2 (.1)2 + (1-)2 (.2)2 + 2 (.7) () (1-) (.1)(.2)

LHS =.0256
.006096 .0256

Put =.320337; RHS =.001026 + .01848 +

So the position is equivalent to

(.3203) (997,662)

$319,589 in 6 month bond

(.6797) (997,662)

$678,074 in 12 month bond

 We can now write the portfolio in terms of 3 month, 6 month, 12 month

zero coupon bonds.

$50,000

$1,050,000

t = .3

t = .8

Total

3 month bond 37,397

--

6 month bond 11,791

319,589

331,380

12 month bond

678,074

678,074

--

37, 397

Let 1, 2, 3 be the volatilities of the 3 month, 6 months, 12 months

bonds and 12, 13, 23 be the respective correlations.

= 12 + 22 + 32 + 21212 + 22323 + 21313

= [(37,397)2 (.06)2 + (331,380)2 (.10)2 + (678,074)2 (.20)2

+ (2) (37,397) (331,380) (.06) (.10) (.90)

+ (2) (331,380) (678,074) (.10) (.20) (.70)

+ (2) (37,397) (678,074) (.06) (.20) (.60)] x 10-4

2,628,536

$1621.3

10 day 99% VAR

1621.3 x 10 x 2.33

$11,946