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Types of Risk
Types of Risk
Market risk
Operating risk
Reputational risk
5%
-10MM
Possible Profit/Loss
• VAR is a measure of the losses due to “normal” market
movements.
VAR(A)+VAR(B)>VAR(A+B)
Expected return:
E ( RP ) xE ( RA ) (1 x) E ( RB )
Variance:
2 ( RP ) x 2 2 ( RA ) (1 x) 2 2 ( RB ) 2 x(1 x)Cov( RA , RB )
Cov( RA , RB )
Correlation: A, B Corr ( R A , RB )
SD( RA ) SD( RB )
corr=-1
corr=1
corr=0
Example:
The 3-month $ and £ interest rates are 5.469% and 6.063% respectively.
£10m $15m
1.5335 1 0.06063(91 / 360) 1 0.05469(91 / 360)
$327,771
• The risk factors are the exchange rate and the interest
rates.
• See Figure 1
Variance-covariance approach
$15m
rUSD X1
1 0.05469(91 / 360)
£10m
rGBP X 2 1.5335
1 rGBP ( 91 / 360 )
£10m
S X 3 S
1 0.06063 (91 / 360 )
Step 2
Assume that percentage changes in the risk factors have a
multivariate Normal distribution with means of zero, and
estimate the parameters of the distribution (standard
deviations, correlation coefficients).
Step 3
Use the standard deviations and correlations of the risk
factors to determine the standard deviations and
correlations of changes in the value of the standardized
positions (using the sensitivities of standardized positions
to changes in the risk factors).
Percentage change in X1:
X 1 / X 1 rUSD
rUSD / rUSD rUSD
X 1 / X 1
1 USD
rUSD / rUSD
rUSD
where USD STDEV
rUSD
Same for X2 and X3:
X 2 / X 2
2 GBP
rGBP / rGBP
X 3 / X 3
3 S
S / S
Step 4
Calculate the portfolio standard deviation using the
properties of Normal distributions:
P X X X 2 X 1 X 2 12 1 2
2
1
2 2
1
2
2
2
2
2
3
2
3
2 X 1 X 3 13 1 3 2 X 2 X 3 23 2 3
VAR 1.65 P
Historical simulation
Then, the possible losses are calculated using the simulated risk factors.
Comparing the methods
Ability to capture the risk of portfolios that include options
Frequency
Normal distribution
Payoff
OPTIONS
Option price Frequency
Frequency
Skewed distribution
Payoff
VAR and options: the Delta-Gamma estimation
Call S the dollar price of British pound and C(S) the option price as a
function of S.
C ( S )
S
For example, if Δ=0.51 and the price changes by $0.01, the predicted
change in the option price is $0.0051=0.51*$0.01
C ( S ) 1 2C ( S ) 2
Change in price dS dS
S 2 S 2
• For historical simulation, there is the risk that recent history is not
typical (volatility).
• Performance measures:
– Mean relative bias
– Root mean squared relative bias
– Annualized percentage volatility
– Fraction of outcome covered
– Multiple needed to attain desired coverage
– Average multiple of tail event to risk measure
– Correlation between risk measure and absolute value of outcome
Stress testing