A VAR MODEL AS RISK MANAGEMENT TOOL AND RISK ADJUSTED

PERFORMANCE MEASURES

Andrea CREMONINO

, Marco GIORGINO
Department of Economics and Production, Politecnico di Milano
Piazza Leonardo da Vinci, 32 - 20133 Milano (Italy)
Abstract
We provide evidence for risk management as a value creation activity. To test this proposition, we introduce risk
control in portfolio decision making where in order to assess risk we developed a VaR model that is able to take in
multidimensional risks. Then we ran out a simulation according to Italian banking operational procedures: our evidence
shows a better performance both as total return and as Sharpie ratio. We argue that Basle standard requirements are less
heavier than ones granted by internal models, modified by prudential coefficients.
Key words: Risk Measures, Risk Management, Performance Measures, and Supervision Authorities Regulation.
JEL classification: G21, G11, and G31.
I ntroduction
In the nineties European banks faced a dramatic change in their competitive environment: the
decrease of interest rates and the growing competition owing to the forthcoming EMU era affected
banks earnings. In order to increase profitability most banks expanded financial activities, so they
had to enforce risk management. Current risk management literature focuses on identifying
equilibrium scenarios in which a firm minimizes the total variability of its cash flows (e.g. Smith
and Stultz (1985) and Froot, Scharfestein and Stein (1993)). In these models, the role is to mitigate
the costs induced by cash flow volatility, that result by capital market imperfections, thus creating
value for shareholders. However, the existing models do not specify the source of variance in the
distribution of firms cash flows. They focus only on the benefits of risk management for reducing
the total risk of a firms portfolio. Consequently, these models ignore multidimensional risks and
the possible covariation among risks within a firm. By contrast this paper provides evidence that
firms can create value by taking risk analysis in decision making: here we introduce an example of
portfolio management.
On the other hand national supervising authorities, forming the Basle Committee developed their
regulatory schemes (Accord in 1988) to take in market risks. Since they adopted a similar

Even if this is the output of a research work jointly carried out by the authors, Marco Giorgino has written Introduction,
and Conclusions, while Andrea Cremonino Paragraphs 1, 2 and 3.

Corresponding Author: Tel. ++39-2-23992778; Fax. ++39-2-23992720; E-mail: andrea.cremonino@polimi.it

approach, the output was a compulsory scheme that provides capital requirements depending on the
amount and riskiness of the securities in banks portfolio. Later Basle Committee encouraged the
development of internal models for risk assessment that could be used to determinate capital
requirements according to a prudential set of coefficients.
This paper provides evidence that such conditions turn internal model into inefficiency because
capital requirements they provide are larger then ones granted by standard model (Sironi 1985).
This paper proceeds as follows. Section I develops the model, the test framework and sample data
are described in Section II, while the results are discussed in Section III. Section IV concludes.
I . Model
Our model builds on the framework of VaR (this model is known in literature, for instance Jorion
(1995) and J.P. Morgan (1995)).
The widest definition of VaR is maximum expected losses in market value of a given
position that can be expected to be incurred on a defined time horizon within a confidence
range.
If we use mathematical formulas:
MV0 * Prob (V< - C) (I)
Where C is fixed loss level and
MV
0
is position market value.
The chosen quantile expresses risk aversion degree because higher values correspond to higher
confidence levels, but that imply larger amounts of adsorbed capital. By the way risk aversion is an
element of competitive policies in some activities or market segments since riskiest
operations have different capital absorption and so different costs according to each
institution.
We assume a confidence level of 95% because this model is meant as management tool,
where we need verify the correctness of estimations.
1
Intuitively VaR is proportional to position sensibility (endogenous factor) times market factor
expected future volatility (exogenous factor).
Market value change is estimated by parametric methods: the market value of a position is
described as a function of position sensibility to relevant variables (e.g. rates and prices). These
methods implicitly contain hypothesis that securities are linear, i.e. change rate of their value is
constant when financial variables evolve (or that we can use a linear functional form).
In order to estimate future variability we model relevant financial variables as random variables
following a lognormal distribution. This is to say that logarithm returns and not financial variables
are normally distributed because the formers keep on having meaning on negative tail.
We chose logarithmic returns instead of arithmetical ones since they enjoy the properties of
symmetry and time series additivity.
Due to the hypothesis introduced above, VaR is shaped as:
VaR = MV
0

-1
() (II)
where MV
0
is market value,
is return volatility
chosen quantile.
This formula requires implicit hypothesis that return mean is zero: J.P. Morgan assumed that
because it was supported by empirical evidence and to avoid misunderstanding whether VaR should
be centered on average, i.e.
VaR = [ -
-1
()] MV
0
(III)
where is return expected value.
If we consider mean too, we cannot express a value in cumulative distribution as a single variable
function of standard deviation. Moreover this means to focus on loss probability (called downside
risk). This hypothesis is the more precise the shorter is time horizon.
In order to assess variance we use a historical method instead of implied volatility because the
formers may be applied to every activity and not only to traded securities and because empirical
evidence supports historical volatility
2
. Within historical estimations, we chose an EWA
(Exponential Weighted Average) method, because it attributes an exponentially decreasing weight
to elder data. The analytical equations are, under condition that [0;1]:
( ) ( )

=
=
1
1
2 2
1
t
n
t
n
FORECAST
r t or recursively: (IV)
( ) ( ) ( )
FORECAST t FORECAST
t r t 1 1
2 2
1
2
+ =

(IV)
We set = 0.94 for daily variance because this value maximizes likelihood function (RiskMetrics

1
A residue of 5% means that we should observe a loss greater then estimated one on average once every twenty days,
while with 99% level once every one hundred days.
2
Jorion [1995]
(1995)).
An unique decay factor provides a simple and easy to understand method and avoids inconsistency
between different estimates (that grants the feasibility of Cholesky decomposition of variance
matrix) while performs better than a GARCH (1,1)
3
.
In estimating volatility from time series we suppose that data are non-serially autocorrelated, i.e.
there is no correlation between an observation and the previous one: that allows to estimate
volatility on a defined time horizon starting from daily standard deviation times square root of
period length. The advantage is to estimate volatility with no need to update huge datasets.
It is more accurate calculate time horizon as trading days because volatility arises in trading, as
shown by empirical research
4
. We observe that this procedure has been adopted by Basle regulation.
The non autocorrelation hypothesis provides a conceptual support not to take in consideration
expected yields: since expected returns and volatilities grow up respectively as time and as its
square root, on the short term the latters are higher.
As a proxy of liquidity risk we may use bid-ask spread (Cherubini (1995)) but it is very hard to
calculate because data requirements grow exponentially; thus we use transaction volumes. Actually
trading volume standard deviation is more accurate since it is more coherent with the model we
developed. We point out that this analysis may be improper because it deals with a micro nature
effect, i.e. a single security spread, with a macro parameter, that is to say referred to whole market.
I I . Test
In order to prove evidence that risk management creates value we implement an empirical
experiment of portfolio management. Thus we need define test framework, then introduce
operational hypothesis, regard sample data and finally chose performance indexes.
II.A How model works
Risk measurement model usefulness may be shown only if it is applied to a portfolio management
example.
We can may schematize how our simulation works by a flow diagram: a set of operation proposals
is an input of the model, they are analyzed sequentially because a proposal is approved only if

3
J. Boudoukh, M. Richardson, R. Stanton, R. Whitelaw [1995]
4
Hull[1993]
portfolio VaR keeps on being under a fixed threshold. Thus an accepted operation is executed and
portfolio is changed, then we consider next one until proposal set is over:
Operations VaR Limits
yes
end of
operations
Basic portfolio Test Update Final portfolio

no
This binary logic may seem too simple, but it is the only one coherent with a risk control model
because this must not evaluate the worthiness of operation selected according to other criteria.
However every operation, also ones our model refuses, is executed on a parallel portfolio, which is
subjected to no control.
That structure aims to pick out first type errors, i.e. accepting a false hypothesis, that means buying
a low return security or selling a high return one.
To be more accurate, we execute our test on two different refused operation sets, named portfolio 1
and portfolio 2, in order to represent a wide spectrum of chances.
We can measure second type of errors, that is to say refusing a correct hypothesis, only comparing
to starting portfolio, because it undergoes no changes.
Such sets differ on a few operations because it would be senseless to refuse many one given limited
sample size
5
.
We regarded also an efficient portfolio, i.e. lying on efficient border, which has the same risk
degree of basic portfolio, but a return of 15%
6
.
II.B Operational hypothesis
In order to build stylized model that meanwhile provides a likely enough representation, we
assumed a set of hypothesis attempting to replicate bank financial activities. These hypotheses are:
- capital allocation: we suppose that capital allocation has already been carried out at a corporate
level;

5
Model portfolio and efficient portfolio undergo 112 operations, while portfolio 1 and 2 respectively 123 and 126.
6
This portfolio is made by BTP (75.11%), and North America (10.44%) bond indices, and Europe (9.63%), Emerging
Europe (3.97%) and Italy (0.85%) stock indices.
- cash limit: beside capital allocated, we can raise funds from an account up to 10%
7
of portfolio
value. This cash is added to get operations more likely and to avoid balancing constraints;
- repurchase operations: we suppose that our bank may execute such operations, subject to
constraints of positive net position due to a prudential management regulation;
- VaR limit: VaR limit is set equal to 110% of average VaR during the previous year. We chose
percentage VaR to be more accurate in order that portfolio increases do not affect constraints;
- discrete events: we suppose to execute operations once a month. At the beginning of each month
value changes are accounted and percentage weights are updated;
- fund payment: we suppose that additional cash must be paid for: we set Libor as funding rate,
because its time series is available. From a conceptual point of view this means fund raising on
interbank markets. A further simplifying hypothesis is debt-credit spread set to zero;
- derivatives: we deal with futures and options: the formers are evaluated with time series, the latter
by delta-gamma approximation;
- type of portfolio: we chose to deal with an asset allocation portfolio because this is coherent with
discrete event hypothesis without affecting model power and generality. Monthly trading volumes
of this simulation are more or less 10%, an intermediate level between trading and asset
allocation: one of Italians major banks moves less than 5% of its asset allocation portfolio each
month.
We chose operation proposals relying on an approach as technical analysis, since in this paper
fundamental analysis would be misleading. Our criteria are:
- selection of securities which much increased their value expecting a further grow;
- sale of securities which increased very much their prices to cash gains, and that implies thinking of
a temporary overvaluation;
- purchase of securities whose value has dramatically fallen in a turnaround perspective, due to an
underevaluation assumption.
A further rule is holding in portfolio a large percentage of bonds in order to represent Italian bank
trading customs.
In order to chose an operation, we always regard risk absorption, so we prefer securities which
determinate the lowest whole risk degree amongst ones with similar expected returns.

7
This limit is a compromise between operational flexibility and budget constraints. As a matter of fact one of major Italian
banks assumed this threshold.
II.C Data
In this simulation, portfolio is not made up by securities, but by indices representing regions due to
their synthesis powerfulness which allows to regard every investment choice: managing with single
shares or bonds would not be feasible due to huge data requirements. Indices are a fairly good
approximation for enough diversified portfolios because they can reflect correctly market
composition.
In order to perform a complete analysis, respecting manageability constraints, we chose only two
categories of indices: stock and bond, the latter coincides with government ones. This
approximation is very sensible because value determining factors of government bonds are the same
as private ones, but vice versa does not hold and above all for different volumes.
In this simulation we chose Morgan Stanley Capital Indices due to their diffusion, flexibility and
they allow a very complete analysis since they cover almost every organized market. We opted to
obtain bond indices by repeating compositions of stock ones
8
, in order to guarantee a homogeneous
analysis.
Two principles inspired index choice: the first is global coverage, the second one is aggregating
countries as homogeneous as possible according to economic and financial development.
A basic element of empirical test is portfolio simulation begins from: we chose the average
portfolio reflecting ones recently hold by Italian banks, though we lightly increased, from 10% to
15%, stock and foreign securities percentages in order to increase test meaningfulness
9
.
Using only one index for domestic bond would be a too inaccurate approximation given that
government bonds make a great percentage of Italian banks portfolio: thus we adopted Bank of
Italy indices which allow to distinguish BOT, CCT, BTP, CTO, CTE and CTZ
10
in order to
represent precisely enough Italian banks portfolios.
Before applying our model, we judged interesting to verify consistency of mathematical hypothesis
we supposed: we synthetically present results from statistical analysis of daily return time series of
indices presented above in 1996 and 1997.
- Anderson-Darling test proves evidence that none series follow normal distribution;
- Bartlett test leads to conclusion that daily returns are correlated with one-day lag;
- we used mean hypothesis tests based on t-Student distribution: there is no statistical evidence to

8
We had to face the lack of data for seven countries: we recalculate weights due to their minor roles and sizes.
9
Its composition is shown in Appendix I; as starting nominal value we set 100 mn $.
10
BOT: zero coupon bonds under a year; CCT: bonds below ten years, usually floating rate ones; BTP: very liquid bonds
ranging from five to thirty years; CTE: bonds expressed in ECU; CTO: bonds with an option; CTZ : two year zero coupon
bonds.
refuse null mean hypothesis for nine time series;
11
- we used a test based on chi-squared statistic in order to control variance. As null hypothesis we
adopted variance estimated value at the end of 1997 due to inertial nature of exponential weighted
averages. More precisely we took variance on December 17
th
to avoid volatility reduction near year-
end: there is no statistical evidence to refuse null mean hypothesis for nine time series
12
.
About liquidity risk assessment available data are not systematic because they are related to a few
markets
13
and since they are on monthly volumes, we could only estimate a variance value, not time
varying.
The scarceness and lower quality of volume data has made impossible estimation of correlation
between market and liquidity risks, so whole exposure may be undervalued
14
.
Variance matrix could be represented as follows:
=
0
+D
BAS
(V)
where
0
is return variance matrix
D
BAS
is a diagonal matrix containing volume variances
II.D Supervising capital requirement
While we deal with risk control, it is interesting to compare capital requirements provided by
internal models with those calculate according to Basle standard model.
Basle committee standard model adopts a building block approach since capital requirements are
calculated separately for each kind of risk and they are added: that means that no correlation is held.
In order to apply such standard model to our portfolio, we supposed some simplifying hypothesis,
listed below:
- we considered as OECD members Japan and countries belonging to North America, Pacific and
Europe indices;
- we chose a bond duration ranging from three and four years, like that obtained for portfolio
descripted above. Such duration corresponds to a risk coefficient of 2.25%;
- we judge that our portfolio is diversified enough to deserve reduction of coefficient to face single
stock specific risks, while the coefficient for general risk is untouched at 8%;
- we applied a coefficient of 2% on total security value to protect against operational risks;

11
These are: Italian, Japanese, north American and Pacific stock indices, and CTE, Emerging Europe, Japanese, Asia and
Pacific bond indices.
12
These are Italian, both European, both American, Japanese, Asian and Pacific stock indices, and Latin American,
Japanese, Asia and Pacific bond indices.
13
We found data about United States (NYSE), France, Germany, United Kingdom, Brazil, Argentina, Canada, beside Italy.
14
Only for Italian markets daily data are available, but we used the same method as other countries for homogeneity sake.
- we assimilate bonds issued by government which do not belong to OECD as qualified ones, so we
apply a 1.6% adding coefficient.
Basle committee allows calculating capital requirements according to models developed by each
financial institution, if they meet quantitative conditions that are:
i. VaR calculated at a 99% confidence level;
ii. time horizon of ten trading days;
iii. a safety coefficient ranging from three to four according on backward performances on the last
two hundred and fifty trading days.
II.E Performance indexes
The total return does not result as a good performance measure since it is incoherent with our model
because the latter uses riskiness as control parameter. It would be meaningless regarding only
returns because we evaluate our model on a parameter it does not control
15
. Thus a suitable index is
profit scaled by risk, i.e. the ratio of profit to VaR, assumed as proxy of risk.
We can choose other indexes as model output, for instance utility functions, but they require
estimation of functional form and of many parameters. Moreover utility functions are not easy to
understand because they express a measure without a direct link with financial variables, even if
they allow representing each investors risk aversion.
In order to present a complete set of risk adjusted performance measures, we regard an index about
relative performance based on VaR. Thus we can use differential VaR, given by the difference
between VaRs, to get an index similar to Information Ratio. This is defined as
VaR
r r
R I

=
0
. . (VI)
where ris investment return
0
r is benchmark return.
Since we set an ex-post perspective, this ratio becomes a performance measure.
As benchmark we chose three-month LIBOR on Italian Lira since bonds percentages in portfolios
we dealt with were quite high. Moreover LIBOR may be regarded as a threshold to outperform
since we used as proxy of funding cost.
Since LIBOR is a three-month rate, we turned that into a daily return in order to be coherent with
other assets, so average rate by compounded capitalization is

15
In Dynamic systems this is a non observable system because output function does not include dependent variable
1 ) 1 (
360
1
360

+ =

=
N N
k
k
LIBOR LIBOR (VII)
where N is fixing number in the period analyzed
k
LIBOR is k-th daily fixing
Variance was estimate using an EWA from daily returns, i.e.
( )
360 1
1
k
LIBOR return daily + = where
k
LIBOR is the k-th day fixing. (VII)
III. Results
Table I presents returns of risk bounded portfolio, according to our model, and the performances of
the three control portfolios described above
16
.
Returns may be gathered in two groups: the risk bounded portfolio and portfolio 1 gained roughly
50% more than portfolio 2 and basic portfolio. Of course efficient portfolio achieves a higher yield.
Yields differ on a few percentage points since limited sample size prevents from high data
dispersion.
Risk controlled portfolio provides the lowest VaR, while basic portfolio VaR is 8% higher than risk
controlled portfolio one due to a low diversification: Italian government bonds sum up to 70% of
latter portfolio. Also efficient portfolio does not exploit completely diversification since it is formed
by a few securities.
Percentage VaR , i.e. VaR as percentage of portfolio value, is a more accurate index since it does
not regard scale effect .We can see that efficient portfolio VaR is affected by portfolio value (see
(II)).
With respect to performance ratio described above, we observe that monitored portfolio
outperforms other portfolios. Efficient portfolio ratio value is the highest due to its return, even if it
is not very far to monitored portfolio.
Logarithmic return and our ratio have not the same ranking of portfolio, though both of them
confirm the better performances of risk controlled portfolios, i.e. risk bounded portfolio and
efficient portfolio, that is the risk minimizing portfolio for a given expected return.
Table I (Numbers in brackets represent test significance).

16
We carried out significance tests on monthly values

in order to check whether results were statistical different, i.e. tests
about means based on a t-statistics defined as
2 2

S S
.
Model
Portfolio
Basic
Portfolio
Portfolio 1 Portfolio 2
Efficient
Portfolio
Final Value [mn $] 119.165 115.851 118.145 112.649 123.315
Log return 0.1753 0.1471 0.1667 0.1191 0.2096
VaR [mn $] 2.561 2.774 3.283
(17)
2.694
(17)
2.846
VaR [%] 2.149 2.394
(13)
2.779
(3)
2.392
(1)
2.308
Ratio 6.847 5.305 5.079 4.421 7.364
Table II compares the standard capital requirements to capital requirements according to internal
models. As we have illustrated above, supervising authorities capital requirements have to be
determined with a 99% quantile, so VaR values our model provides must be scaled in order to
change quantile and then multiplied by a safety coefficient that we set to minimum, i.e. 3
17
.
We prove evidence that the internal models become more expensive, that is to say they require
more capital, than standard model: here the overcharge ranges from 22% to 54%. This is due to the
conservative attitude toward internally developed model, since without safety coefficient, the
internal model capital requisites should be the half of ones given by standard model.
Basle requirements are quite similar, except two outliers made by portfolio 1 and basic portfolio.
Table II points out the role of risk control since portfolio 2 and efficient portfolio have similar
capital requirements but the latter return doubles the formers one.
Table II (Numbers in brackets represent test significance).
Model
Portfolio
Basic
Portfolio
Portfolio 1 Portfolio 2
Efficient
Portfolio
VaR [mn $] 2.561 2.774 3.283
(17)
2.694
(17)
2.846
Internal Capital Requirements [mn $] 10.866 9.449 13.929
(17)
11.430
(17)
12.075
Standard Capital Requirements [mn $] 8.450 4.254
(1)
10.450 8.936 9.083

17
We disregard the increase due to model inaccuracy: for instance our model failed five times dealing with basic portfolio in
1997, so the safety coefficient should arise from 3 to 3.40, according to Basle Committee regulations.
Table III introduces performance according to Information Ratio defined above. The best
performance, efficient portfolio, is three times the worst one and is 30% higher than the second
best.
Table III (Numbers in brackets represent test significance).
Model
Portfolio
Basic
Portfolio
Portfolio 1 Portfolio 2 Efficient
Portfolio
Final Value [mn $] 119.165 115.851 118.145 112.649 123.315
Log return 0.1753 0.1471 0.1667 0.1191 0.2096
VaR [mn $] 2.561 2.774 3.283
(17)
2.694
(17)
2.846
VaR [%] 2.149 2.394
(13)
2.779
(3)
2.392
(1)
2.308
Ratio 6.847 5.305 5.079 4.421 7.364
Var [%] 10.875 9.673 12.906 11.999 11.296
I.R. 1.133 0.813 0.875 0.484 1.458
We remark that most measure s are consistent with each other, as a matter of fact Final value,
logarithmic return, Ratio and Information ratio have the same portfolio ranking. Percentage VaR
provides similar results while absolute VaR is quite different since it is affected by size effect.
Thus each financial firm should use more than one measure, for instance choosing an index as main
one, and monitoring other ones as feasibility control, as performance against a benchmark or
funding cost.
Conclusions
This paper proposes an approach to analyze risk assessment when multiple risks are bundled within
a firms decision making.
We introduced a model, relying on the VaR framework, that allows an integrated measure of
financial risks. In order to demonstrate the risk analysis creates value, we implemented our model in
a case of portfolio management: we built a sequential procedure based on a binary investment
decision making. We introduced some operational hypothesis and constraints in order to reproduce
procedures used by Italian banks.
As performance index we used the ratio of return and VaR because the total return is not related to
risk, that is the control parameter of our model.
The results of simulation provide evidence, as we predicted, that risk management creates value as a
matter of fact risk controlled portfolio gained a higher return, both as total return and as return
scaled by risk, measured by VaR. The capital requirements given by Basle standard model are
smaller than ones given by VaR modified by safe coefficient.
Moreover we developed a sensitivity analysis to check effects induced by changes in definitions and
value of parameters: the results did not change their qualitative pattern.
Bibliography
J.BOUDOUKH, M. RICHARDSON, R. STANTON and R. WHITELAW (1995): A New
Strategy
for Dynamically Hedging Mortagage-Backed Securities, Journal of
Derivates
U. CHERUBINI (1997): Risk management toward the EMU era: a review of techniques
and future
challenges, Collana Ricerche, Banca Commerciale Italiana
T.H.DONALDSON (1989): Credit Risk and Exposure in Securitisation and Transactions,
Mac Millan, London;
K. FROOT, D.SCHARFESTEIN, J. STEIN(1993): Risk management: Coordinating
investment
and financing policies, Journal of Finance 48, 1629-1658
J.HULL (1993): Options, Futures and Other Derivative Securities, Englewood Cliffs,
Prentice Hall, 2
nd
edition;
P.JORION (1995): Value at risk: the new benchmark for controlling market risk, Irwin;
JP MORGAN (1995): RiskMetrics

technical document, New York;
A.SIRONI (1995): Gestione del rischio e allocazione del capitale nelle banche, Milano,
EGEA.
( Risk management and capital allocation in banks)
C.SMITH, R. STULZ (1985): The determinants of firms hedging policies
Journal of Financial and Quantitative Analysis 28, 391-405.
APPENDIX I: BASIC PORTFOLIO COMPOSITION
COUNTRY INDEX WEIGHT [%]
ITALY STOCK INDEX 12,75
L BOT INDEX 18,70
L CCT INDEX 24,65
L BTP INDEX 24,65
L CTO INDEX 1,70
L CTE INDEX 1,70
L CTZ INDEX 0,85
EUROPA STOCK INDEX 0,7875
BOND INDEX 4,4625
EM EU+MIDEAST STOCK INDEX 0,225
BOND INDEX 1,275
NORTH AMERICA STOCK INDEX 0,450
BOND INDEX 2,5500
EM LAT AM FREE STOCK INDEX 0,1125
BOND INDEX 0,6375
JAPAN STOCK INDEX 0,28125
BOND INDEX 1,59375
EM ASIA FREE STOCK INDEX 0,225
BOND INDEX 1,275
PAC FREE X JAPAN STOCK INDEX 0,16875
BOND INDEX 0,95625