Presentation on theme: "Analytical Approaches to Non-Linear Value at Risk"— Presentation transcript:
1Analytical Approaches to Non-Linear Value at Risk Simon Hubbert, Birkbeck College London
2Overview Review Value at Risk approaches for linear portfolios. Consider the case for a portfolio of derivatives.Use Taylor approximations to derive closed form solutions.Based on: Non-linear Value at Risk : Britten-Jones and Schaeffer: European Finance Review
3Portfolio Monitoring Invest in n Risky Assets: Portfolio value today: Potential future loss/profit:where
4Normal Value at RiskQ. How much are we likely to lose % of the time over the future period?A. The number that satisfies:If thenTypically or
5Non-linear Portfolio Invest in n derivatives: Each is a non-linear function of andPotential future loss/profit:we cannot assume the are normally distributed.We need to approximate…
6Simple Approximations 1st Order – Delta Approximation:2nd Order – Gamma Approximation:
7Coping with high dimensionality A large number of derivatives in the portfolio creates high computational demands.Eg. The covariance structure:requires numbers.We introduce a factor model:where
8Employing Delta Approximation With the Factor model we consider:The delta approximation then becomes:In vector notation:
9Delta Normal VaRSuppose that:whereThen..Given a small we have:
10Employing Gamma Approximation The Delta VaR is known to be a weak estimate (see BJ&S 1999).We turn to the gamma approximation:With a single factor this becomes:
11Gamma approx cont’d How is distributed ? It is a quadratic: Complete the square - consider:Expand and match:and
12Towards Gamma VaR If we assume that then: Furthermore: Use statistical tables to find
13Gamma VaR Since We see that is equivalent to: Thus we can read off VaR estimates:
14Gamma VaR: the multi-factor case BJ & S (1999) show that gamma VaR provides a much more accurate estimates than the delta approach applied to long options.We want to modify our analysis to cover multi-factor modelling:Idea: Use the approach used in the single factor case to develop a strategy.
15Multi-factor Gamma approximation The approximate profit/loss is given byWhere::
16Distribution of gamma approx Recall – Single factor case we considered:and found thatIn the multi-factor case we set and analogously we can show:where,
17Variable Transformations We assume thatwhere is positive definite:andTo make simplifications we set:
18Towards Gamma approx With these transformations we can neatly write: One step further – spectral decomposition of B:Orthonormal matrix of Eigenvectors.Eigenvalues of B.
19The Gamma Approximation One final transformation:Yields:A sum of squares of normal random variables each with unit variance, i.e., a sum of non-central chi-squared random variables.
20Approximating the distribution What more can we say about ?We can write down analytic expressions for its moments:1st2nd3rd
21An idea.. The distribution of is not known. However.. We have expressions for the integer moments.Idea: Fit the moments to a more tractable distributionHope for a good approximation to
22A candidate random variable Britten-Jones and Schaeffer (1999) consider a chi-squared random variable:where with p degrees of freedom.Such a random variable was proposed by Solomon and Stephens (1977) - showed that it can provide a good approximation to a sum of chi-square variables.
23A distributional approximation The integer moments of the random variableare given by…where denotes the gamma function.
24Moment matchingWe have analytic expressions for the integer moments of both:andMatching moments gives values for and
25Gamma VaR Using the approximation We can read, from a table of , values such thatWe then set:For an appropriate confidence level .
26Overview How to compute analytical non-linear VaR: Set up a factor modelEmploy first or second order Taylor approximations.Assume a distribution for the risk factors (eg, normal).Using the first order approximation with multi-factorsAnalytical solution – Delta VaR.Using the second order approximation with single factorAnalytical solution – Gamma VaRUsing the second order approximation with multi-factorsSemi-analytical solution – Approximate Gamma VaR
27Numerical FindingsNumerical tests (BJ-S 1999) against Monte Carlo approach, suggest that:Delta approximations provide weak estimates of VaR.Gamma approximation (with a single factor) improves the VaR estimates – however a single factor assumption may not be realistic.Success of the approximate gamma VaR (with many factors) to VaR estimates is very dependent upon the curvature of the derivatives. Encouraging results are reported for portfolios of long European options.
28Bibliography Britten-Jones, M and S. M. Schaeffer: (1999) Non-Linear Value at RiskEconomic Finance Review 2: pp 161 – 187.Solomon, H and M. A. Stephens (1977)Distribution of a sum of weighted chi-square variablesJournal of American Statistical Association 72: