Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C.

Hull 2009



Chapter 13
Market Risk VaR: Model-
Building Approach
1
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
The Model-Building Approach
The main alternative to historical simulation is to
make assumptions about the probability
distributions of the returns 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
2
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Microsoft Example (page 267-8)
We have a position worth $10 million in
Microsoft shares
The volatility of Microsoft is 2% per day
(about 32% per year)
We use N=10 and X=99
3
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Microsoft Example continued
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 10 456 , $632,
4
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Microsoft Example continued
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, the VaR is
2 33 632 456 473 621 . , $1, ,
5
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
AT&T Example
Consider a position of $5 million in AT&T
The daily volatility of AT&T is 1% (approx
16% per year)
The SD per 10 days is

The VaR is


50 000 10 144 , $158,
158114 2 33 405 , . $368,
6
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Portfolio (page 268)
Now consider a portfolio consisting of both
Microsoft and AT&T
Suppose that the correlation between the
returns is 0.3
7
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
S.D. of Portfolio
A standard result in statistics states that


In this case s
X
= 200,000 and s
Y
= 50,000
and r = 0.3. The standard deviation of the
change in the portfolio value in one day is
therefore 220,227





Y
X Y X Y X
s rs s s s

2
2 2
8
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
VaR for Portfolio
The 10-day 99% VaR for the portfolio is

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?
657 , 622 , 1 $ 33 . 2 10 220,227
9
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
The Linear Model
We assume
The daily change in the value of a portfolio
is linearly related to the daily returns from
market variables
The returns from the market variables are
normally distributed
10
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
When Linear Model Can be Used
Portfolio of stocks
Portfolio of bonds
Forward contract on foreign currency
Interest-rate swap
11
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
The Linear Model and Options

Consider a portfolio of options dependent
on a single stock price, S. Define


and


S
P

S
S
x


12
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Linear Model and Options
continued
As an approximation

Similarly when there are many underlying
market variables


where
i
is the delta of the portfolio with
respect to the ith asset


x S S P

i
i i i
x S P
13
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Example
Consider an investment in options on Microsoft
and AT&T. Suppose the stock prices are 120
and 30 respectively and the deltas of the
portfolio with respect to the two stock prices are
1,000 and 20,000 respectively
As an approximation

where x
1
and x
2
are the percentage changes
in the two stock prices



2 1
000 , 20 30 000 , 1 120 x x P
14
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
But the distribution of the daily
return on an option is not normal

The linear model fails to capture skewness
in the probability distribution of the
portfolio value.
15
But the distribution of the daily
return on an option is not normal
(See Figure 13.1, page 279)
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
16

Positive Gamma
Negative Gamma
Translation of Asset Price Change
to Price Change for Long Call
(Figure 13.2, page 279)
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
17
Long
Call
Asset Price
Translation of Asset Price Change
to Price Change for Short Call
(Figure 13.3, page 280)
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
18
Short
Call
Asset Price
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Monte Carlo Simulation (page 282)
To calculate VaR using MC simulation we
Value portfolio today
Sample once from the multivariate
distributions of the x
i

Use the x
i
to determine market variables
at end of one day
Revalue the portfolio at the end of day
19
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Monte Carlo Simulation continued
Calculate P
Repeat many times to build up a
probability distribution for P
VaR is the appropriate fractile of the
distribution times square root of N
For example, with 1,000 trial the 1
percentile is the 10th worst case.
20
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Speeding up Calculations with the
Partial Simulation Approach
Use the approximate delta/gamma
relationship between P and the x
i
to
calculate the change in value of the
portfolio
This can also be used to speed up the
historical simulation approach
21
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Alternative to Normal Distribution
Assumption in Monte Carlo
In a Monte Carlo simulation we can
assume non-normal distributions for the x
i
(e.g., a multivariate t-distribution)
Can also use a Gaussian or other copula
model
22
Risk Management and Financial Institutions 2e, Chapter 13, Copyright John C. Hull 2009
Model Building vs Historical
Simulation
Model building approach can be used for
investment portfolios where there are no
derivatives, but it does not usually work
when for portfolios where
There are derivatives
Positions are close to delta neutral
23