Tail-Risk Analysis In R: Part II: Extreme Value Theory

By James PicernoMarket OverviewFeb 07, 2017 07:21AM ET

James Picerno
Articles (1943)
My Homepage
Follow
The financial crisis of 2008 devastated portfolios far and wide and brought
the global economy to the brink of collapse. It was a disaster, but there
was at least one positive outcome from the debacle: a wider recognition
that tail risk is a real and present danger thats forever lurking. The
challenge is deciding how to model and manage the risk. You wont find
any easy solutions, but there are practical tools for estimating a portfolios
vulnerability.
In Part I of tail risk analysis I reviewed the pros and cons of value at risk
(VaR) and estimated shortfall (ES), two of the more popular quantitative
tools for getting a handle on the probability that an asset or portfolio will
suffer an usually steep loss at some point. The limits of these metrics are
widely known, particularly for VaR. Can we do better? Yes, according to
advocates of extreme value theory (EVT), which is considered a more
reliable and robust methodology for estimating the demons that lie in wait
in the outliers of the return distributions for assets, markets, and
investment portfolios.

EVT traces its theoretical roots to research in the 1920s, but the
application for investing is a relatively recent development that begins in
the 1990s. The logic for using EVT is that it offers a superior framework for
modeling financial market risks extreme losses in particular.

The main challenge with analyzing so-called left-tail events is the paucity
of data. By definition, unusually steep losses that occur, say, 1% of the
time are rare, which means that the empirical cupboard is nearly bare. In
turn, modeling events that are infrequent is statistically and
econometrically challenging, and so the standard metrics are typically
useless. EVT attempts to step into the breach with a solution.
As an example, lets analyze a simple 60/40 stock/bond portfolio, based
on the Vanguard 500 Index (VFINX) to represent equities and Vanguard
Intermediate-Term Treasury (VFITX) for bonds. The portfolio will be
rebalanced back to the target weights at the end of each calendar year,
using a start date of Dec. 31, 1991 through yesterday (Feb. 6, 2017). The
analytics will be run in R, using the fExtremes package to fit the EVT
model. Heres the code to replicate the results that follow.

Lets begin with reviewing the full distribution of daily returns for the
60/40 portfolio. As Figure 1 shows, the empirical history can be
approximated with a normal distribution (red line), but its hardly a perfect
fit.
Figure 1

Distribution of 1-Day Portfolio Returns

Although Figure 1 appears to show that the losses are normally

distributed, reality is quite different once we zoom in on the left side of the
tail (i.e., the distribution of the negative returns). In Figure 2, its clear that
losses occur with greater frequency than a normal distribution allows.
Figure 2
1-Year Left Tail

The cumulative distribution function (CDF) provides a more useful tool for
visually inspecting the return distribution vs. the standard histogram. The
CDF of the 60/40 portfolio returns shows the range of probabilities that a
return will be equal to or less than a specific value. For example, the
normal distribution line (indicated in red) in Figure 3, as it moves from left
to right, reflects a rising probability (vertical axis) of a higher return
(horizontal axis). For instance, theres a roughly 40% probability of a zero-
percent (or less) return for the portfolio on any given day. But the
empirical history (black line) doesnt exactly match the red line and so
caution is recommended for assuming that a normal distribution applies.
Figure 3
ECDF

Zooming in on the left-tail portion of the CDF plot (Figure 4) clearly shows
that the 60/40 losses occur more frequently than expected via a normal
distribution. Yes, the probability of a loss is quite low, according to the
empirical record. But that offers little comfort since we know that at some
point the 60/40 portfolio will suffer a steep loss, perhaps more frequently
and deeply than the historical record implies.
Figure 4
ECDF: Left Tail

Figure 4 above tells us that the steepest daily loss for the 60/40 portfolio
was a bit more than 4%. A nave review of history would simply accept
this decline as the worst-case scenario. Further, the empirical record
shows that there were only nine days with losses of 3% or higher
representing a mere 0.14% of the daily returns since 1991. But that low-
risk estimate may be an artifact of a specific historical sample. In other
words, the historical period were using to estimate tail risk may be
misleading. How can we develop a higher-confidence estimate of the
worst-case scenarios with so little data to analyze? This is where EVT can
help. As Jon Danielsson notes in Financial Risk Forecasting

, an appealing aspect of EVT is that it does not require a prior assumption

about the return distribution.

The tricky part of EVT is deciding how to select a threshold value for the
returns. There are several methodologies, but for illustration purposes
lets use a simple one by eyeballing the point that appears to separate the
left tail from the rest of the distribution. Figure 5 shows a so-called Q-Q
plot, which compares the sample quantiles of return with the theoretical
quantiles. If the actual returns (black circles) were distributed normally
(red line), the circles would align with the red line. Thats true for the
center of the distribution, but at the tail ends the circles show significant
deviation. The question for EVT modeling is where that deviation begins?
As a rough approximation, lets assume that returns at negative 1% and
below define the left tail, as indicated by the horizontal blue line.
Figure 5

Normal Q-Q Plot

Now that we have a 1% threshold estimate we can model the 60/40

portfolio with EVT. One possibility for running the analytics is using a
generalized Pareto distribution (GPD), which is a common choice for
modeling tail events. As Figure 6 shows, after crunching the numbers its
clear that the GPD fit (green line) is considerably better for modeling
extreme returns vs. the normal distribution (red line).
Figure 6
Left Tail: Empirical Cumulative Distribution Function

One way to put the EVT results to work is to estimate VaR and ES with the
model parameters. In this case, however, the 60/40 risk estimates via EVT
arent all that different than the results generated with the conventional
techniques for calculating VaR and ES (see Table A). But this may be a
function of the 60/40 portfolio. For other investment strategies, the EVT-
based estimates of VaR and ES may be considerably different.
Table A

Risk Metrics

A more powerful application of EVT modeling is running a Monte Carlo

simulation to test outcomes that could occur by synthetically creating the
equivalent of far longer periods of performance history. In the historical
sample above, the data is limited to the 1991-2017 period, which
translates to a bit more than 12,600 daily returns. Lets increase the
performance loss sample dramatically by simulating 1 million daily returns
based on our EVT modeling above for a deeper read on the left-tail
possibilities with the 60/40 portfolio. The result is shown in Figure 7.
Figure 7

Simulated Left-Tail Density Histogram

Although the chart appears to profile the right tail, its actually showing
the left-tail estimates. As you can see, the potential for losses are
considerably greater compared with what the 1991-2017 historical record
implies. The deepest daily loss in that history was a bit more than 4%. By
contrast, the EVT-based simulation above tells us that the losses
approaching 35% are possible. As a practical matter, most of the
simulated losses max out at roughly 15%. The probability is extremely low
of seeing anything larger.

The main point is that an EVT-based evaluation of tail risk for the 60/40
portfolio is substantially higher than history suggests. That doesnt mean
that much bigger losses will occur. But in the interest of stress testing a
portfolio its crucial to develop a quantitatively reliable estimate of the
worst-case scenarios. EVT isnt perfect, but it may be the best solution
compared with the alternatives in the dark art/science of modeling tail
risk.
Tail-Risk Analysis In R: Part II: Extreme Value Theory

Add a Comment
Related Articles
Add a Comment
Comment Guidelines

Post

Disclaimer: Fusion Media would like to remind you that the data contained in this website is not necessarily real-
time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by
market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are
indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any
trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of
reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be
fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest
investment forms possible.