Value at Risk Various Models and Its Ap
Value at Risk Various Models and Its Ap
Value at Risk Various Models and Its Ap
Abstract
“Value at Risk” has been one of the prime tools for measurement of risk since its inception.
Fundamental building blocks of VaR model have been identified and different combinations of
components have been applied in the Indian context. Along with simple VaR model, some
complicated VaR models have also been back tested in Indian Scenario.
1. Introduction
As a measure of Risk, “Value at Risk” has been one of the prime tools in financial
industry. Value at Risk (VaR) is a quantitative measure of risk, which exhibits that
over a given period (say in 10 days period) the loss amount (VaR) is expected to
exceed only y% (say 1 %, i.e. 100-X, where X=99%) of the time.
Value at risk was first designed by Dennis Weatherstone, the erstwhile Chairman of
J.P. Morgan & Co. This was a one page report that could measure the total risk faced
by J.P.Morgan & Co. globally.
2. Approaches to Calculate VaR
There are various approaches to calculate the VaR. Some of these are as below:
a. Monte Carlo Simulation: Monte Carlo Simulation is used to generate the
probability distribution for value change (in rupee terms) in the
investment of a portfolio in one day, one week or any specific time
intervals.
b. Historical Simulation: Historical simulations represent the simplest way of
estimating the Value at Risk for many portfolios. In this approach, the VaR
for a portfolio is estimated by creating a hypothetical time series of
returns on that portfolio, obtained by running the portfolio through
actual historical data and computing the changes that would have
occurred in each period on each market risk factor.
c. Model Building Approach: This process map the risk in the individual
investments in the portfolio to more general market risks, and then
estimate the measure based on these market risk exposures.
Thus testing the VaR model with above components, two assets were selected from
NSE traded Stocks. Two Stocks – namely the prices of L&T and LUPIN have been
taken from 30th October, 2015 to 28th January, 2016
5 . The methods & Models used:
1. Volatility was estimated, which were based on the prices of respective stock
prices for 60 days. This estimation was done using GARCH(1,1) method.
2. For calculation of volatility, based on the GARCH (1,1) method, the mean and
variance for each day each underlying was calculated.
3. Then, using Maximum Likelihood Method, the value of a, w & b was found.
For maximization, the algorithm with SOLVER of Excel was used. It gives
localized maximization for the defined equation. After finding w,a & b, the
values of y was taken and then long run volatility, daily volatility and annual
volatility was estimated.
4. The Co-relation coefficient between the stocks was calculated with COREL
function with the exponential weight of the time series. As the time series
progresses, the older periods have also considered, thus forming a reliable
co-relation.
5. Further the Standard deviations of both the stocks and the standard
deviation for portfolio were calculated and the VAR of Portfolio calculated.
GARCH(1,1)
In order to estimate the historical volatility, GARCH(1,1) model was used. A study
of comparing volatility models done by Hansen and Lunde, using GARCH(1,1) as
benchmark, had as result that the best models do not provide a significantly better
forecast than the GARCH(1,1) model. For this reason GARCH(1,1) is preferred here
above all family of GARCH models.
At present, there have been many models developed to determine volatility, and
some of them act as alternatives or improvement from earlier models. The family of
GARCH models is an example, starting from the autoregressive conditional
heteroskedasticity (ARCH) model of Engle (1982).
The least square approach assumes that the squared errors have the same magnitude
across the entire dataset. This assumption is known as homoskedasticity. But these
data, having periods of high and low volatility, cluster together. This is known as
Heteroskedasticity. In reference to modeling fitting, this means the residuals vary
color. Portfolio VaR line is significantly below the Additive VaR line at most of the
time period of 60 days. Whereas at chart 2 the individual stocks’ one day VaR line
have been plotted for reference.
130
125
V 120
A
ONE DAY VAR
R 115
ADDITIVE VAR
110
105
100
0 10 20 30 40 50 60
TIME
Chart 1
70.00
V 65.00
A
1 Day_VaR_L&T
R 60.00
1 Day_VaR_LUPIN
55.00
50.00
0 10 20 30 40 50 60
TIME
Chart 2
8. Reference:
a. Jarrow, Robert A. & Chatterjea, Arkadev (2016), An Introduction to
Derivatives Securities, Financial Markets and Risk Management, 1st ed.,
Viva, India
b. Hull, J.C. (1993), Options, Futures, and other Derivative Securities, 2nd ed.,
Prentice Hall, NJ.
c. Skoglund, J., Erdman, Donald., Chen, Wei., November 1, Spring 2010, “The
performance of value at risk models during the crisis”, The Journal of Risk
Model Validation.
d. Bollerslev, T. (1986). “Generalized autoregressive conditional
hetroskedasticity”. Journal of Econometrics, 31, 307-327
e. Duffie, Darrell & Pan, Jun, January 21st, 1997, “An Overview of Value at
risk”
f. Hopper, P. Gregory, July/ Aug-1996, “Value at Risk: A new Methodology
for measuring portfolio Risk”, Business Review, Philadelphia FED,
g. Luenberger, David G.(2006), Investment Science, 1st ed., Oxford University
Press