W3-Value at Risk.pptVIP

Subjective vs. Objective Probabilities Objective probabilities are calculated from data Subjective probabilities is base don a individual’s judgment. Objective probabilities are inevitably backward looking The procedure just described is a way of combining subjective and objective probabilities * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Value at Risk * 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?” * 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 * VaR vs. Expected Shortfall VaR is the loss level that will not be exceeded with a specified probability Expected shortfall is the expected loss given that the loss is greater than the VaR level Although expected shortfall is theoretically more appealing than VaR, it is not widely used * 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?” * Estimating VaR:Historical Simulation Create a database of the daily movements in all market variables. The first simulation trial assumes that the percentage changes in all market variables are as on the first day The second simulation trial assumes that the percentage changes in all market variables are as on the second day and so on * Suppose we use 501 days of historical data Let vi be the value of a market variable on day i There are 500 simulation trials The ith trial assumes that the value of the market variable tomorrow is vn (vi / vi-1 ) * Estimating VaR:Historical Simulation The portfolio’s value tomorrow is calculated for each simulation trial The gain or loss between today and tomorrow is then calculated for each trial The losses are ranked and the one-day 99% VaR is set equal to the 5th worst loss * Estimating VaR:Historical Simulation The m