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Chapter 25 Risk Assessment

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Introduction Risk assessment is the evaluation of distributions of outcomes, with a focus on the worse that might happen. Insurance companies, for example, are in the business of determining the likelihood of, and loss associated with, an insured event.

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Value at Risk Value at risk (VaR) is a way to perform risk assessment for complex portfolios. In general, computing value at risk means finding the value of a portfolio such that there is a specified probability that the portfolio will be worth at least this much over a given horizon. Regulators have proposed assessing capital at three times the 99% 10-day VaR

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Value at Risk There are at least three uses of value at risk: 1. Regulators can use VaR to compute capital requirements for financial institutions. 2. Managers can use VaR as an input in making risk-taking and risk-management decisions. 3. Managers can also use VaR to assess the quality of the bank’s models (accuracy of the bank models’ predictions of its own losses).

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Value at risk for one stock Suppose is the dollar return on a portfolio over the horizon h, and f (x, h) is the distribution of returns. Define the value at risk of the portfolio as the return, x h (c), such that Suppose a portfolio consists of a single stock and we wish to compute value at risk over the horizon h.

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Value at risk for one stock If we pick a stock price and the distribution of the stock price after h periods, S h, is lognormal, then (24.5)

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Example Assume you have $3M worth of stock, with an expected return of 15%, a 30% volatility, and no dividend. You know (from cumulative Normal distribution tables) that the 95% lower tail corresponds to a z-value of Compute the value that your portfolio has a 95% chance of exceeding in one week. Infer the VAR.

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Example - Solution The value of the “95% position” is given by: Hence we get: S h = $ million And the VAR is: $ 3 million - $ million = $ m

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Value at risk for one stock In practice, it is common to simplify the VaR calculation by assuming a normal return rather than a lognormal return. A normal approximation is: (24.7) We could further simplify by ignoring the mean: Mean is hard to estimate precisely. For short horizons, the mean is less important than the diffusion term in an Itô process. (24.8) Both equations become less reasonable as h grows.

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Example Assume you have $3M worth of stock, with an expected return of 15%, a 30% volatility, and no dividend. You know (from cumulative Normal distribution tables) that the 95% lower tail corresponds to a z-value of Compute the value that your portfolio has a 95% chance of exceeding in one week. Infer the VAR.

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Example - Solution Using the following formula: We obtain: S = 3 ( 1+.15(1/52) (.30)*sqrt(1/52) ) S = And the VAR is: $ 3m - $ m = $ m that we stand to loose.

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Two or more stocks When we consider a portfolio having two or more stocks, the distribution of the future portfolio value is the sum of lognormally distributed random variables. Since the distribution is no longer lognormal, we can use the normal approximation.

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Two or more stocks Let the annual mean of the return on stock i, r i, be i. The standard deviation of the return on stock i is i. The correlation between stocks i and j is ij. The dollar investment in stock i is W i. The value of a portfolio containing n stocks is

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Two or more stocks If there are n assets, the VaR calculation requires that we specify the standard deviation for each stock, along with all pairwise correlations. The return on the portfolio over the horizon h, R h, is Assuming normality, the annualized distribution of the portfolio return is (24.9)

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VaR for nonlinear portfolios If a portfolio contains options as well as stocks, it is more complicated to compute the distribution of returns. The sum of the lognormally distributed stock prices is not lognormal. The option price distribution is complicated. There are two approaches to handling nonlinearity: 1. Delta approximation: We can create a linear approximation to the option price by using the option delta. 2. Monte Carlo simulation: We can value the option using an appropriate option pricing formula and then perform Monte Carlo simulation to obtain the return distribution.

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Delta approximation If the return on stock i is, we can approximate the return on the option as, where i is the option delta. Let N i be the number of options and i the number of shares of the stock. The expected return on the stock and option portfolio over the horizon h is then (24.10) The term i + N i i measures the exposure to stock i. The variance of the return is (24.11) With this mean and variance, we can mimic the n-stock analysis.

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Monte Carlo simulation Monte Carlo simulation works well in situations where we need a two- tailed approach to VaR (e.g., straddle). Simulation produces the distribution of portfolio values. To use Monte Carlo simulation, We randomly draw a set of stock prices. Once we have the portfolio values corresponding to each draw of random prices, we sort the resulting portfolio values in ascending order. The 5% lower tail of portfolio values, for example, is used to compute the 95% value at risk.

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Monte Carlo simulation Example 1: Consider the 1-week 95% value at risk of an at-the-money written straddle on 100,000 shares of a single stock. Assume that S = $100, K = $100, = 30%, r = 8%, t = 30 days, and = 0. The initial value of the straddle is $685,776.

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Monte Carlo simulation First, we randomly draw a set of z ~ N(0,1), and construct the stock price as (24.13) Next, we compute the Black-Scholes call and put prices using each stock price, which gives us a distribution of straddle values. We then sort the resulting straddle values in ascending order. The 5% value is used to compute the 95% value at risk.

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Monte Carlo simulation Histogram of values resulting from 100,000 random simulations of the value of the straddle: The 95% value at risk is $943,028 ( $685,776) = $257,252.

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Monte Carlo simulation Note that the value of the portfolio never exceeds $597,000. If a call and put are written on the same stock, stock price moves can never induce the two to appreciate together. The same effect limits a loss. When options are written on different stocks, it is possible for both to gain or lose simultaneously. As a result, the distribution of prices has a greater variance and increased value at risk.

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Monte Carlo simulation Example 2: Histogram of values of a portfolio that contains a written put and call having different, correlated underlying stocks.

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Estimating volatility Volatility is the key input in any VaR calculation. In most examples, return volatility is assumed to be constant and returns are independent over time. Assessing return correlation is complicated. Over horizons as short as a day, returns may be negatively correlated due to factors such as bid-ask bounce. With commodities, return independence is not reasonable for long horizons due to supply and demand responses.

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Implied volatility Option prices can be used to estimate implied volatility, which is a forward-looking measure of volatility. However, implied volatility is not readily available for some underlying assets. For VaR calculations, we also need to know correlations between assets, for which there is no measure comparable to implied volatility. A conceptual problem is which volatility to use when different options give different implied volatilities.

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Historical volatility Historical volatility estimates are typically used in VaR calculations. Here are two rolling n-day measures of volatility: a. (24.18) where r t is the daily continuously compounded return on day t. b. (24.19)

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Historical volatility V is the standard estimator for volatility. is an estimate that gives more weight to recent returns and less to older returns. This estimator is called an exponential weighted moving average (EWMA) estimate of volatility. In both measures, we ignore the mean, which is small for daily returns.

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Historical volatility Volatility estimates for IBM and the S&P 500 using the two measures:

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