IEOR E4602: Quantitative Risk Management

Basic Concepts and Techniques of Risk Management

Martin Haugh
Department of Industrial Engineering and Operations Research
Columbia University
Email: martin.b.haugh@gmail.com

References: Chapter 2 of 2nd ed. of MFE by McNeil, Frey and Embrechts.

 Outline

Risk Factors and Loss Distributions

Linear Approximations to the Loss Function
Conditional and Unconditional Loss Distributions

Risk Measurement
Scenario Analysis and Stress Testing
Value-at-Risk
Expected Shortfall (ES)

Standard Techniques for Risk Measurement

Evaluating Risk Measurement Techniques

Other Considerations

2 (Section 0)
 Risk Factors and Loss Distributions
Notation (to be used throughout the course):
∆ a fixed period of time such as 1 day or 1 week.
Let Vt be the value of a portfolio at time t∆.
So portfolio loss between t∆ and (t + 1)∆ is given by

Lt+1 := − (Vt+1 − Vt )

- note that a loss is a positive quantity

- it (of course) depends on change in values of the securities.

More generally, may wish to define a set of d risk factors

Zt := (Zt,1 , . . . , Zt,d )

so that
Vt = f (t, Zt ).
for some function f : R+ × Rd → R.
3 (Section 1)
 Risk Factors and Loss Distributions
e.g. In a stock portfolio might take the stock prices or some function of the
stock prices as our risk factors.

e.g. In an options portfolio Zt might contain stock factors together with implied
volatility and interest rate factors.

Let Xt := Zt − Zt−1 denote the change in values of the risk factors between
times t and t + 1.

Then have

Lt+1 (Xt+1 ) = − (f (t + 1, Zt + Xt+1 ) − f (t, Zt ))

Given the value of Zt , the distribution of Lt+1 depends only on the distribution
of Xt+1 .

Estimating the (conditional) distribution of Xt+1 is then a very important goal in

much of risk management.

4 (Section 1)
 Linear Approximations to the Loss Function
Assuming f (·, ·) is differentiable, can use a first order Taylor expansion to
approximate Lt+1 :
d
!
X
L̂t+1 (Xt+1 ) := − ft (t, Zt )∆ + fzi (t, Zt ) Xt+1,i (1)
i=1

where f -subscripts denote partial derivatives.

First order approximation commonly used when Xt+1 is likely to be small

- often the case when ∆ is small, e.g. ∆ = 1/365 ≡ 1 day, and market not
too volatile.
Second and higher order approximations also based on Taylor’s Theorem can also
be used.

Important to note, however, that if Xt+1 is likely to be very large then Taylor
approximations can fail.

5 (Section 1)
 Conditional and Unconditional Loss Distributions
Important to distinguish between the conditional and unconditional loss
distributions.

Consider the series Xt of risk factor changes and assume that they form a
stationary time series with stationary distribution FX .

Let Ft denote all information available in the system at time t including in

particular {Xs : s ≤ t}.

Definition: The unconditional loss distribution is the distribution of Lt+1 given

the time t composition of the portfolio and assuming the CDF of Xt+1 is given
by FX .

Definition: The conditional loss distribution is the distribution of Lt+1 given

the time t composition of the portfolio and conditional on the information in Ft .

6 (Section 1)
 Conditional and Unconditional Loss Distributions
If the Xt ’s are IID then the conditional and unconditional distributions coincide.

For long time horizons, e.g. ∆ = 6 months, we might be more inclined to use the
unconditional loss distribution.

However, for short horizons, e.g. 1 day or 10 days, then the conditional loss
distribution is clearly the appropriate distribution
- true in particular in times of high market volatility when the unconditional
distribution would bear little resemblance to the true conditional distribution.

7 (Section 1)
 Example: A Stock Portfolio
Consider a portfolio of d stocks with St,i denoting time t price of the i th stock
and λi denoting number of units of i th stock.

Take log stock prices as risk factors so

Xt+1,i = ln St+1,i − ln St,i
and
d
X
λi St,i e Xt+1,i − 1 .


Lt+1 = −
i=1
Linear approximation satisfies
d
X d
X
L̂t+1 = − λi St,i Xt+1,i = −Vt ωt,i Xt+1,i
i=1 i=1

where ωt,i := λi St,i /Vt is the i th portfolio weight.

h i
If E[Xt+1,i ] = µ and Covar(Xt+1,i ) = Σ, then Et L̂t+1 = −Vt ω 0 µ and
 
Vart L̂t+1 = Vt2 ω 0 Σω.
8 (Section 1)
 Example: An Options Portfolio
Recall the Black-Scholes formula for time t price of a European call option with
strike K and maturity T on a non-dividend paying stock satisfies

C (St , t, σ) = St Φ(d1 ) − e −r(T−t) K Φ(d2 )

St


log K+ (r + σ 2 /2)(T − t)
where d1 = √
σ T −t
√
d2 = d1 − σ T − t

and where:
Φ(·) is the standard normal distribution CDF
St = time t price of underlying security
r = continuously compounded risk-free interest rate.

In practice use an implied volatility, σ(K , T , t), that depends on strike, maturity
and current time, t.

9 (Section 1)
 Example: An Options Portfolio
Consider a portfolio of European options all on the same underlying security.

If the portfolio contains d different options with a position of λi in the i th option,

then
Lt+1 = −λ0 (St+1 − St ) −
d
X
λi (C (St+1 , t + 1, σ(Ki , Ti , t + 1) − C (St , t, σ(Ki , Ti , t)))
i=1

where λ0 is the position in the underlying security.

Note that by put-call parity we can assume that all options are call options.

Can also use linear approximation technique to approximate Lt+1

- would result in a delta-vega-theta approximation.

For derivatives portfolios, the linear approximation based on 1st order Greeks is
often inadequate
- 2nd order approximations involving gamma, volga and vanna might then be
used – but see earlier warning regarding use of Taylor approximations.
10 (Section 1)
 Risk Factors in the Options Portfolio
Can again take log stock prices as risk factors but not clear how to handle the
implied volatilities.

There are several possibilities:

1. Assume the σ(K , T , t)’s simply do not change
- not very satisfactory but commonly assumed when historical simulation is
used to approximate the loss distribution and historical data on the changes
in implied volatilities are not available.

2. Let each σ(K , T , t) be a separate factor. Not good for two reasons:
(a) It introduces a large number of factors.
(b) Implied volatilities are not free to move independently since no-arbitrage
assumption imposes strong restrictions on how volatility surface may move.

Therefore important to choose factors in such a way that no-arbitrage restrictions

are easily imposed when we estimate the loss distribution.

11 (Section 1)
Risk Factors in the Options Portfolio
3. In light of previous point, it may be a good idea to parameterize the
volatility surface with just a few parameters
- and assume that only those parameters can move from one period to the next
- parameterization should be so that no-arbitrage restrictions are easy to
enforce.

4. Use dimension reduction techniques such as principal components analysis

(PCA) to identify just two or three factors that explain most of the
movements in the volatility surface.

12 (Section 1)
 Example: A Bond Portfolio
Consider a portfolio containing quantities of d different default-free zero-coupon
bonds.

Thei th bond has price Pt,i , maturity Ti and face value 1.

st,Ti is the continuously compounded spot interest rate for maturity Ti so that

Pt,i = exp(−st,Ti (Ti − t)).

There are λi units of i th bond in the portfolio so total portfolio value given by
d
X
Vt = λi exp(−st,Ti (Ti − t)).
i=1

14 (Section 1)
 Example: A Bond Portfolio
Assume now only parallel changes in the spot rate curve are possible
- while unrealistic, a common assumption in practice
- this is the assumption behind the use of duration and convexity.

Then if spot curve moves by δ the portfolio loss satisfies

d
X  
Lt+1 = − λi e −(st+∆,Ti +δ)(Ti −t−∆) − e −st,Ti (Ti −t)
i=1
d
X
' − λi (st,Ti (Ti − t) − (st+∆,Ti + δ)(Ti − t − ∆)) .
i=1

Therefore have a single risk factor, δ.

15 (Section 1)
Approaches to Risk Measurement
1. Notional Amount Approach.
2. Factor Sensitivity Measures.
3. Scenario Approach.
4. Measures based on loss distribution, e.g. Value-at-Risk (VaR) or Conditional
Value-at-Risk (CVaR).

16 (Section 2)
 An Example of Factor Sensitivity Measures: the Greeks
Scenario analysis for derivatives portfolios is often combined with the Greeks to
understand the riskiness of a portfolio
- and sometimes to perform a P&L attribution.

Suppose then we have a portfolio of options and futures

- all written on the same underlying security.

Portfolio value is the sum of values of individual security positions

- and the same is true for the portfolio Greeks, e.g. the portfolio delta,
portfolio gamma and portfolio vega. Why?

Consider now a single option in the portfolio with price C (S, σ, . . .).

Will use a delta-gamma-vega approximation to estimate risk of the position

- but approximation also applies (why?) to the entire portfolio.

Note approximation only holds for “small” moves in underlying risk factors
- a very important observation that is lost on many people!
17 (Section 2)
 Delta-Gamma-Vega Approximations to Option Prices
A simple application of Taylor’s Theorem yields
∂C 1 ∂2C ∂C
C (S + ∆S, σ + ∆σ) ≈ C (S, σ) + ∆S + (∆S)2 + ∆σ
∂S 2 ∂S 2 ∂σ
1
= C (S, σ) + ∆S δ + (∆S)2 Γ + ∆σ vega.
2
Therefore obtain
Γ
P&L ≈ δ∆S + (∆S)2 + vega ∆σ
2
= delta P&L + gamma P&L + vega P&L .
When ∆σ = 0, obtain the well-known delta-gamma approximation
- often used, for example, in historical Value-at-Risk (VaR) calculations.

Can also write

2
ΓS 2
  
∆S ∆S
P&L ≈ δS + + vega ∆σ
S 2 S
= ESP × Return + $ Gamma × Return2 + vega ∆σ (2)
where ESP denotes the equivalent stock position or “dollar” delta.
18 (Section 2)
 Scenario Analysis and Stress Testing

– Stress testing an options portfolio written on the Eurostoxx 50.

19 (Section 2)
 Scenario Analysis and Stress Testing
In general we want to stress the risk factors in our portfolio.

Therefore very important to understand the dynamics of the risk factors.

e.g. The implied volatility surface almost never experiences parallel shifts. Why?
- In fact changes in volatility surface tend to follow a square root of time
rule.

When stressing a portfolio, it is also important to understand what risk factors

the portfolio is exposed to.
e.g. A portfolio may be neutral with respect to the two most “important" risk
factors but have very significant exposure to a third risk factor
- Important then to conduct stresses of that third risk factor
- Especially if the trader or portfolio manager knows what stresses are applied!

20 (Section 2)
 Value-at-Risk
Value-at-Risk (VaR) the most widely (mis-)used risk measure in the financial
industry.

Despite the many weaknesses of VaR, financial institutions are required to use it
under the Basel II capital-adequacy framework.

And many institutions routinely report VaR numbers to shareholders, investors or

regulatory authorities.

VaR is calculated from the loss distribution

- could be conditional or unconditional
- could be a true loss distribution or some approximation to it.

Will assume that horizon ∆ has been fixed so that L represents portfolio loss
over time interval ∆.

Will use FL (·) to denote the CDF of L.

22 (Section 2)
 Value-at-Risk
Definition: Let F : R → [0, 1] be an arbitrary CDF. Then for α ∈ (0, 1) the
α-quantile of F is defined by
qα (F ) := inf{x ∈ R : F (x) ≥ α}.

If F is continuous and strictly increasing, then qα (F ) = F −1 (α).

For a random variable L with CDF FL (·), will often write qα (L) instead of
qα (FL ).
Since any CDF is by definition right-continuous, immediately obtain the
following result:
Lemma: A point x0 ∈ R is the α-quantile of FL if and only if
(i) FL (x0 ) ≥ α and
(ii) FL (x) < α for all x < x0 .

Definition: Let α ∈ (0, 1) be some fixed confidence level. Then the VaR of the
portfolio loss at the confidence interval, α, is given by VaRα := qα (L), the
α-quantile of the loss distribution.
23 (Section 2)
 VaR for the Normal Distributions
Because the normal CDF is both continuous and strictly increasing, it is
straightforward to calculate VaRα .

So suppose L ∼ N(µ, σ 2 ). Then

VaRα = µ + σΦ−1 (α) (3)

where Φ(·) is the standard normal CDF.

This follows from previous lemma if we can show FL (VaRα ) = α

- but this follows immediately from (3).

24 (Section 2)
 VaR for the t Distributions
The t CDF also continuous and strictly increasing so again straightforward to
calculate VaRα .

So let L ∼ t(ν, µ, σ 2 ), i.e. (L − µ)/σ has a standard t distribution with ν > 2

degrees-of-freedom (dof). Then

VaRα = µ + σtν−1 (α)

where tν is the CDF for the t distribution with ν dof.

Note that now E[L] = µ and Var(L) = νσ 2 /(ν − 2).

25 (Section 2)
Weaknesses of VaR
1. VaR attempts to describe the entire loss distribution with just a single
number!
- so significant information is lost
- this criticism applies to all scalar risk measures
- one way around it is to report VaRα for several values of α.

2. Significant model risk attached to VaR

- e.g. if loss distribution is heavy-tailed but a light-tailed, e.g. normal,
distribution is assumed, then VaRα will be severely underestimated as α → 1.

3. A fundamental problem with VaR is that it can be very difficult to estimate

the loss distribution
- true of all risk measures based on the loss distribution.

4. VaR is not a sub-additive risk measure so that it doesn’t lend itself to

aggregation.

26 (Section 2)
 (Non-) Sub-Additivity of VaR
e.g. Let L = L1 + L2 be the total loss associated with two portfolios, each with
respective losses, L1 and L2 .

Then
qα (FL ) > qα (FL1 ) + qα (FL2 ) is possible!

An undesirable property as we would expect some diversification benefits

when we combine two portfolios together.
Such a benefit would be reflected by the combined portfolio having a
smaller risk measure than the sum of the two individual risk measures.

Will discuss sub-additivity property when we study coherent risk measures later in
course.

27 (Section 2)
 Advantages of VaR
VaR is generally “easier” to estimate:
True of quantile estimation in general since quantiles are not very sensitive
to outliers.
- not true of other risk measures such as Expected Shortfall / CVaR
Even then, it becomes progressively more difficult to estimate VaRα as
α→1
- may be able to use Extreme Value Theory (EVT) in these circumstances.

But VaR easier to estimate only if we have correctly specified the appropriate
probability model
- often an unjustifiable assumption!

Value of ∆ that is used in practice generally depends on the application:

For credit, operational and insurance risk ∆ often on the order of 1 year.
For financial risks typical values of ∆ are on the order of days.

28 (Section 2)
 Expected Shortfall (ES)
Definition: For a portfolio loss, L, satisfying E[|L|] < ∞ the expected shortfall
at confidence level α ∈ (0, 1) is given by
Z 1
1
ESα := qu (FL ) du. (4)
1−α α

Relationship between ESα and VaRα is therefore given by

Z 1
1
ESα := VaRu (L) du
1−α α

- so clear that ESα (L) ≥ VaRα (L).

29 (Section 2)
 Expected Shortfall (ES)
A more well known representation of ESα (L) holds when FL is continuous:

Lemma: If FL is a continuous CDF then

E [L; L ≥ qα (L)]
ESα :=
1−α

= E [L | L ≥ VaRα ] . (5)

Proof: See Lemma 2.13 in McNeil, Frey and Embrechts (MFE). 2

Expected Shortfall also known as Conditional Value-at-Risk (CVaR)

- when there are atoms in the distribution CVaR is defined slightly differently
- but we will continue to take (4) as our definition.

30 (Section 2)
 Example: Expected Shortfall for a Normal Distribution
Can use (5) to compute expected shortfall of an N(µ, σ 2 ) random variable.

We find
φ (Φ−1 (α))
ESα = µ + σ (6)
1−α
where φ(·) is the PDF of the standard normal distribution.

31 (Section 2)
 Example: Expected Shortfall for a t Distribution
Let L ∼ t(ν, µ, σ 2 ) so that L̃ := (L − µ)/σ has a standard t distribution with
ν > 2 dof.

Then easy to see that ESα (L) = µ + σESα (L̃).

Straightforward using direct integration to check that

gν (tν−1 (α)) ν + (tν−1 (α))2

 
ESα (L̃) = (7)
1−α ν−1

where tν (·) and gν (·) are the CDF and PDF, respectively, of the standard t
distribution with ν dof.

Remark: The t distribution is a much better model of stock (and other asset)
returns than the normal model. In empirical studies, values of ν around 5 or 6 are
often found to fit best.

32 (Section 2)
 The Shortfall-to-Quantile Ratio
Can compare VaRα and ESα by considering their ratio as α → 1.

Not too difficult to see that in the case of the normal distribution

ESα
→ 1 as α → 1.
VaRα
However, in the case of the t distribution with ν > 1 dof we have

ESα ν
→ > 1 as α → 1.
VaRα ν−1

33 (Section 2)
Standard Techniques for Risk Measurement
1. Historical simulation.
2. Monte-Carlo simulation.
3. Variance-covariance approach.

34 (Section 3)
 Historical Simulation
Instead of using a probabilistic model to estimate distribution of Lt+1 (Xt+1 ), we
could estimate the distribution using a historical simulation.

In particular, if we know the values of Xt−i+1 for i = 1, . . . , n, then can use this
data to create a set of historical losses:

{L̃i := Lt+1 (Xt−i+1 ) : i = 1, . . . , n}

- so L̃i is the portfolio loss that would occur if the risk factor returns on date
t − i + 1 were to recur.

To calculate value of a given risk measure we simply assume the distribution of

Lt+1 (Xt+1 ) is discrete and takes on each of the values L̃i w.p. 1/n for
i = 1, . . . , n, i.e., we use the empirical distribution of the Xt ’s.

e.g. Suppose we wish to estimate VaRα . Then can do so by computing the

α-quantile of the L̃i ’s.

35 (Section 3)
 Historical Simulation
Suppose the L̃i ’s are ordered by

L̃n,n ≤ · · · ≤ L̃1,n .

Then an estimator of VaRα (Lt+1 ) is L̃[n(1−α)],n where [n(1 − α)] is the largest
integer not exceeding n(1 − α).

Can estimate ESα using

f α = L̃[n(1−α)],n + · · · + L̃1,n .
ES
[n(1 − α)]

Historical simulation approach generally difficult to apply for derivative portfolios.

Why?
But if applicable, then easy to apply.

Historical simulation estimates the unconditional loss distribution

- so not good for financial applications!

36 (Section 3)
 Monte-Carlo Simulation
Monte-Carlo approach similar to historical simulation approach.

But now use some parametric distribution for the change in risk factors to
generate sample portfolio losses.

The (conditional or unconditional) distribution of the risk factors is estimated

and m portfolio loss samples are generated.

Free to make m as large as possible

Subject to constraints on computational time.
Variance reduction methods often employed to obtain improved estimates of
required risk measures.

While Monte-Carlo is an excellent tool, it is only as good as the model used to

generate the data: if the estimated distribution of Xt+1 is poor, then
Monte-Carlo of little value.

37 (Section 3)
 The Variance-Covariance Approach
In the variance-covariance approach assume that Xt+1 has a multivariate normal
distribution so that
Xt+1 ∼ MVN (µ, Σ) .
Also assume the linear approximation
d
!
X
L̂t+1 (Xt+1 ) := − ft (t, Zt )∆ + fzi (t, Zt ) Xt+1,i
i=1

is sufficiently accurate. Then can write

L̂t+1 (Xt+1 ) = −(ct + bt > Xt+1 )

for a constant scalar, ct , and constant vector, bt .

Therefore obtain
 
L̂t+1 (Xt+1 ) ∼ N −ct − bt > µ, bt > Σbt .

and can calculate any risk measures of interest.

38 (Section 3)
 The Variance-Covariance Approach
This technique can be either conditional or unconditional
- depends on how µ and Σ are estimated.
The approach provides straightforward analytically tractable method of
determining the loss distribution.

But it has several weaknesses: risk factor distributions are often fat- or
heavy-tailed but the normal distribution is light-tailed
- this is easy to overcome as there are other multivariate distributions that are
also closed under linear operations.
e.g. If Xt+1 has a multivariate t distribution so that

Xt+1 ∼ t (ν, µ, Σ)

then  
L̂t+1 (Xt+1 ) ∼ t ν, −ct − bt > µ, bt > Σbt .

A more serious problem is that the linear approximation will often not work well
- particularly true for portfolios of derivative securities.
39 (Section 3)
 Evaluating Risk Measurement Techniques
Important for any risk manger to constantly evaluate the reported risk measures.

e.g. If daily 95% VaR is reported then should see daily losses exceeding the
reported VaR approximately 95% of the time.

So suppose reported VaR numbers are correct and define


1, Li ≥ VaRi
Yi :=
0, otherwise

where VaRi and Li are the reported VaR and realized loss for period i.

If Yi ’s are IID, then

n
X
Yi ∼ Binomial(n, .05)
i=1

Can use standard statistical tests to see if this is indeed the case.

Similar tests can be constructed for ES and other risk measures.

40 (Section 3)
Other Considerations
Risk-Neutral and Data-Generating (Empirical) Probability Measures.
Data Risk.
Multi-Period Risk Measures and Scaling.
Model Risk.
Data Aggregation.
Liquidity Risk.
P&L Attribution.

41 (Section 4)