Value at Risk and
Expected Shortfall
Chapter 12
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
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?
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
VaR and Regulatory Capital
Regulators
base the capital they require
banks to keep on VaR
The market-risk capital has traditionally
been calculated from a 10-day VaR
estimated where the confidence level is
99%
Credit risk and operational risk capital are
based on a one-year 99.9% VaR
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
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?
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
Example 12.1 (page 185)
The
gain from a portfolio during six month
is normally distributed with mean $2
million and standard deviation $10 million
The 1% point of the distribution of gains is
22.3310 or $21.3 million
The VaR for the portfolio with a six month
time horizon and a 99% confidence level
is $21.3 million.
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
Example 12.2 (page 186)
All
outcomes between a loss of $50 million
and a gain of $50 million are equally likely
for a one-year project
The VaR for a one-year time horizon and a
99% confidence level is $49 million
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
Examples 12.3 and 12.4 (page 186)
A
one-year project has a 98% chance of
leading to a gain of $2 million, a 1.5%
chance of a loss of $4 million, and a 0.5%
chance of a loss of $10 million
The VaR with a 99% confidence level is $4
million
What if the confidence level is 99.9%?
What if it is 99.5%?
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
Cumulative Loss Distribution for
Examples 12.3 and 12.4 (Figure 12.3, page
186)
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
VaR vs. Expected Shortfall
VaR is the loss level that will not be exceeded with a
specified probability
Expected shortfall (ES) is the expected loss given that
the loss is greater than the VaR level (also called C-VaR
and Tail Loss)
Regulators have indicated that they plan to move from
using VaR to using ES for determining market risk capital
Two portfolios with the same VaR can have very different
expected shortfalls
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
Distributions with the Same VaR but
Different Expected Shortfalls
VaR
VaR
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
10
Coherent Risk Measures (page 188)
Define a coherent risk measure as the amount of
cash that has to be added to a portfolio to make its
risk acceptable
Properties of coherent risk measure
If one portfolio always produces a worse outcome than
another its risk measure should be greater
If we add an amount of cash K to a portfolio its risk measure
should go down by K
Changing the size of a portfolio by should result in the risk
measure being multiplied by
The risk measures for two portfolios after they have been
merged should be no greater than the sum of their risk
measures before they were merged
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
11
VaR vs Expected Shortfall
VaR
satisfies the first three conditions but
not the fourth one
ES satisfies all four conditions.
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
12
Example 12.5 and 12.7
Each of two independent projects has a probability 0.98
of a loss of $1 million and 0.02 probability of a loss of
$10 million
What is the 97.5% VaR for each project?
What is the 97.5% expected shortfall for each project?
What is the 97.5% VaR for the portfolio?
What is the 97.5% expected shortfall for the portfolio?
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
13
Examples 12.6 and 12.8
A bank has two $10 million one-year loans. Possible outcomes are
as follows
Outcome
Probability
Neither Loan Defaults
97.5%
Loan 1 defaults, loan 2 does not default
1.25%
Loan 2 defaults, loan 1 does not default
1.25%
Both loans default
0.00%
If a default occurs, losses between 0% and 100% are equally likely.
If a loan does not default, a profit of 0.2 million is made.
What is the 99% VaR and expected shortfall of each project
What is the 99% VaR and expected shortfall for the portfolio
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
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Spectral Risk Measures
1.
2.
3.
4.
A spectral risk measure assigns weights to
quantiles of the loss distribution
VaR assigns all weight to Xth percentile of the
loss distribution
Expected shortfall assigns equal weight to all
percentiles greater than the Xth percentile
For a coherent risk measure weights must be a
non-decreasing function of the percentiles
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
15
Normal Distribution Assumption
When losses (gains) are normally distributed
with mean and standard deviation
VaR N 1 ( X )
ES
Y 2 2
e
2 (1 X )
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
16
Changing the Time Horizon
If
losses in successive days are
independent, normally distributed, and
have a mean of zero
T - day VaR 1 - day VaR T
T - day ES 1 - day ES T
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
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Extension
there is autocorrelation between the
losses (gains) on successive days, we
replace T by
If
T 2(T 1) 2(T 2) 2 2(T 3) 3 2 T 1
in these equations
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
18
Ratio of T-day VaR to 1-day VaR (Table 12.1,
page 193)
T=1
T=2
T=5
T=10
T=50
T=250
1.0
1.41
2.24
3.16
7.07
15.81
=0.05 1.0
1.45
2.33
3.31
7.43
16.62
=0.1 1.0
1.48
2.42
3.46
7.80
17.47
=0.2 1.0
1.55
2.62
3.79
8.62
19.35
=0
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
19
Choice of VaR Parameters
Time horizon should depend on how quickly
portfolio can be unwound. Regulators are
planning to move toward a system where ES is
used and the time horizon depends on liquidity.
(See Fundamental Review of the Trading Book)
Confidence level depends on objectives.
Regulators use 99% for market risk and 99.9%
for credit/operational risk.
A bank wanting to maintain a AA credit rating
might use confidence levels as high as 99.97%
for internal calculations.
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
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Aggregating VaRs
An approximate approach that seems to works
well is
VaR total
VaR VaR
i
ij
where VaRi is the VaR for the ith segment,
VaRtotal is the total VaR, and ij is the coefficient
of correlation between losses from the ith and
jth segments
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
21
VaR Measures for a Portfolio where an
amount xi is invested in the ith component
of the portfolio (page 195-196)
Marginal
VaR:
VaR
xi
Incremental
VaR: Incremental effect of
the ith component on VaR
Component
VaR:
VaR
xi
xi
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
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Properties of Component VaR
The
component VaR is approximately the
same as the incremental VaR
The total VaR is the sum of the component
VaRs (Eulers theorem)
The component VaR therefore provides a
sensible way of allocating VaR to different
activities
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
23
Back-testing (page 197-200)
Back-testing a VaR calculation methodology involves
looking at how often exceptions (loss > VaR) occur
Alternatives: a) compare VaR with actual change in
portfolio value and b) compare VaR with change in
portfolio value assuming no change in portfolio
composition
Suppose that the theoretical probability of an exception
is p (=1X). The probability of m or more exceptions in n
days is
n
n!
k
nk
p
(
1
p
)
k m k!( n k )!
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
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Bunching
Bunching
occurs when exceptions are not
evenly spread throughout the back testing
period
Statistical tests for bunching have been
developed by Christoffersen (See page 200)
Risk Management and Financial Institutions 4e, Chapter 12, Copyright John C. Hull 2015
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