1

Is there any advantage of holding a combination of X and Y?

Stock X Stock Y

Expected Return 20 30

Expected Variance 16 25

Covariance XY 20
 Covariance and Correlation
Correlation coefficient varies from -1 to +1

Cov ij
rij 
 i j
where :
rij  the correlation coefficient of returns
 i  the standard deviation of R it
 j  the standard deviation of R jt
 Index (X) Stock (Y)
Beta 904.95 597.8
845.75 570.8
Beta (β) is a measure of the volatility—or
874.25 582.95
systematic risk—of a security or portfolio
compared to the market as a whole 847.95 559.85
(usually the S&P 500).
849.1 554.6
835.8 545.1
816.75 519.15
843.55 560.7
835.55 560.95
839.5 597.4
4
Value at Risk

5
Learning Outcomes

 Appraise with the concept of VAR and its impact on

business and financial risk.

 Measure the collaborative risk of an organization

with different concepts/techniques under VAR.

6
 Value at Risk
It is the probability that a portfolio will experience a mark-to-market
loss that exceeds that of a specific predetermined threshold value.

 Essentially this means that value at risk is measured in three

variables:

 The amount of potential loss,

 The probability of that loss, and
 The timeframe.

7
The Question Being Asked in VaR

“What loss level is such that we are X% confident it will not be

exceeded in N business days?”

 Example of value at risk (VaR)

 If a portfolio has a VaR of 10% on a certain day of $10 million

USD, then this portfolio has a 0.10 probability that the
portfolio will drop in value by $10 million. A loss of more than
the VaR threshold is considered to be a “VaR break”.

8
The illustration shows that the portfolio’s expected return is $50m.
Additionally, the probability of realizing a return of less than $42m is 5%.

9
VaR and Regulatory Capital

Regulators base the capital they require

banks to keep on VaR

The market-risk capital is k times the 10-

day 99% VaR where k is at least 3.0

10
VaR vs. C-VaR

 VaR is the loss level that will not be exceeded with a

specified probability

 C-VaR (or expected shortfall) is the expected loss

given that the loss is greater than the VaR level

 Although C-VaR is theoretically more appealing, it is

not widely used

11
Advantages of VaR

 It captures an important aspect of risk

in a single number

 It is easy to understand

 It asks the simple question: “How bad can things

get?”

12
QUIZ
A hypothetical portfolio B has an annual 1% VaR of
$45,000. Which of the following statements is most
likely true about the portfolio?

a) The expected minimum loss over one year, 1% of the time, is

$45,000.

b) There is a 99% probability that the expected loss over the

next year is more than $45,000.

c) The likelihood of losing $45,000 over the next year is 1%.

https://analystprep.com/study-notes/cfa-level-2/explain-the-use-of-value-at-risk-var-in-measuring-portfolio-risk/
VaR (Interpretation)
 VaR represents the maximum possible loss on a portfolio over
a given period in the future, with a given degree of confidence.

 The degree of confidence is typically expressed as 1−p.

 if an asset has a one-day 5% VaR of $7,500, What does it

suggest?

14
The Variance-Covariance Method

 This method assumes that stock returns are

normally distributed.

 In other words, it requires that we estimate only two

factors - an expected (or average) return and a
standard deviation - which allow us to plot a
normal distribution curve. Here we plot the normal
curve against the same actual return data:

15
The Variance-Covariance
Method

16
The Variance-Covariance Method
 The advantage of the normal curve is that we automatically
know where the worst 5% and 1% lie on the curve. They are a
function of our desired confidence and the standard deviation ():

Confidence of Standard Deviations (σ)

95% (high) - 1.65 x σ
99% (really high) - 2.33 x σ

 The average daily return happened to be fairly close to zero, so we will

assume an average return of zero for illustrative purposes.

17
Time Horizon
 Instead of calculating the 10-day, 99% VaR directly
analysts usually calculate a 1-day 99% VaR and
assume

10 - day VaR  10  1- day VaR

 This is exactly true when portfolio changes on

successive days come from independent identically
distributed normal distributions

18
The Model-Building Approach
 The main alternative to historical simulation is to
make assumptions about the probability
distributions of return on the market variables and
calculate the probability distribution of the change
in the value of the portfolio analytically

 This is known as the model building approach or

the variance-covariance approach

19
Daily Volatilities
 In option pricing we measure volatility “per year”

 In VaR calculations we measure volatility “per day”

 year
 day 
252

20
Daily Volatility continued

 Strictly speaking we should define day as the

standard deviation of the continuously
compounded return in one day

 In practice we assume that it is the standard

deviation of the percentage change in one day

21
Microsoft Example

 We have a position worth $10 million in Microsoft

shares

 The volatility of Microsoft is 2% per day

 We use N=10 and X=99

22
Microsoft Example
 The standard deviation of the change in the
portfolio in 1 day is $200,000

 The standard deviation of the change in 10 days is

200 , 000 10  $632 , 456

23
Microsoft Example
 We assume that the expected change in the value of the
portfolio is zero (This is OK for short time periods)
 We assume that the change in the value of the portfolio is
normally distributed
 Since N(–2.33)=0.01,
 It means that there is 1% probability that a normal distributed

variable will decrease by more than 2.33 S.D.

So the 10-day 99% VaR for Microsoft is:

2 .33  632 ,456  $1,473 ,621

24
AT&T Example
 Consider a position of $5 million in AT&T
 The daily volatility of AT&T is 1%

25
AT&T Example
 Consider a position of $5 million in AT&T
 The daily volatility of AT&T is 1%

 The S.D per 10 days is

50 ,000 10  $158,144

 The VaR is

158 ,114  2 .33  $368, 405

26
Portfolio
 Now consider a portfolio consisting of both
Microsoft and AT&T

 Suppose that the correlation between the returns is

0.3

27
S.D. of Portfolio
A standard result in statistics states that

 X  Y   2X   Y2  2  X  Y

 In this case X = 200,000 andY = 50,000 and  =

0.3.

28
S.D. of Portfolio
A standard result in statistics states that

 X  Y   2X   Y2  2  X  Y

 In this case X = 200,000 andY = 50,000 and  =

0.3.
 The standard deviation of the change in the
portfolio value in one day is therefore 220,227

29
 VaR for Portfolio

 The 10-day 99% VaR for the portfolio is

220,227  10  2 . 33  $ 1, 622 , 657

 The benefits of diversification are

(1,473,621+368,405)–1,622,657=$219,369
 What is the incremental effect of the AT&T holding
on VaR?

30