Asset Management

Group Assignment
Risk Measurement
and
Risk Budgeting

Introduction
In this work we computed VaR according to different methodologies. In particular, we used
Parametric with simple 100-days historical volatility
Parametric with EWMA volatility on 100 days (decay factor 0.94)
Simple historical simulation 100 days
Simple historical simulation based on 500 days
Filtered historical simulation (100 days) by the use of the EWMA volatility estimates
calculated for the parametric model
by considering 95% and 99% as desired confidence level for both returns and active returns.
A brief description of each method is provided below.

Parametric with simple historical volatility

This is the most basic way to compute historical volatility. First, the standard deviation of returns
for the sample period is estimated. Then, a confidence level for a certain measure is specified
(typically a number between 95% and 99%) and, by using the inverse of the cumulative density
function, the z-value corresponding to the specified confidence level is computed. If a mean equal
to zero is assumed, then VaR is simply the product between the z-value and the variance. The
main drawback of this procedure is that the assumption that returns are normally distributed
holds and it is not true in reality, especially for tail returns.

Parametric with EWMA volatility

A weight, which is function of the return chronological order, is attributed to each return so that
older returns will have a lower weight, while recent returns will have a higher weight (typically, an
EWMA is used). Then the weighted average of squared returns is calculated by using as weights
the values coming from the EWMA. From this last step a sort of weighted variance is obtained.
The square root of the weighted variance is computed and its result is multiplied for the z-value of
the normal distribution associated to the confidence level previously specified. This will be the VaR
for the selected sample. This is probably the most effective way to have a reactive measure of risk.

Simple historical simulation 100 days

The empirical cumulative distribution function is built by taking into account actual past returns,
and such a distribution is cut at the desired confidence level. The return got from the cut is the
VaR. On the one hand, the main advantage of this method is that there is no need to specify a
distribution function (it is only assumed that the observed empirical distribution will be stable over
time and that returns are IID). On the other hand, the chief drawback is that risk measures
obtained are very stable over time. Moreover, it is likely that the echo effect could be experienced
when adopting historical simulations since it is possible to notice leaps in the plot of VaR. This is
due to the fact that when an extreme return goes out from the sample, then the curve suddenly
goes up, even if nothing has happened in the market.

Filtered historical simulation by the use of the EWMA volatility estimates

Each return is standardized through a given volatility measure. In our study, we chose a simple
EWMA as standardizing measure. The empirical density function of standardized returns is cut at a
given percentile. The resulting value is the VaR. The standardizing procedure is performed in order
to take into account the fact that returns are not unconditionally normal, but that they become
normally distributed when they are conditioned to volatility.

Results

Absolute VaR at 95%

0,00%
-0,50%
-1,00%
-1,50%
-2,00%
VaR 95% PAR 100D
VaR 95% HS 100D
VaR 95% Filtered HS 100D EWMA

VaR 95% EWMA(0,94)

VaR 95% HS 500D

Absolute VaR at 99%

0,00%
-0,50%
-1,00%
-1,50%
-2,00%
-2,50%
-3,00%
-3,50%
VaR 99% PAR 100D
VaR 99% HS 100D
VaR 99% Filtered HS 100D EWMA

VaR 99% EWMA(0,94)

VaR 99% HS 500D

It is easy to notice in the plot the echo effect, typical of VaR calculated with historical simulations.
This is due to the fact that as a sizeable shock enters the observation sample the risk value
skyrockets whilst, when a remarkable shock goes out of the rolling window the VaR suddenly goes
down. You can also see that this effect is much more pronounced when estimating 99% VaR.

In order to make sure that computations were right, we performed a very simple consistency
check, that is we checked that 99% VaR was higher in absolute value than 95% VaR. As it is
possible to expect, it results that 99% VaR gives rise to higher risk values compared to 95% VaR
ones. We calculated also the average difference between the 99% and the 95% risk measure for
each approach and we discovered that the filtered historical simulation produced the highest
change in risk measure. When the confidence margin was changed, the filtered historical approach
made risk measure increase of roughly 1%. When we used other approaches, such a change was
around 0.50%.
The most reactive risk measure appears to be VaR calculated through an EWMA, while the most
stable is the VaR computed by using the 500 days historical simulation.
It appears that there is no approach yielding an ever low risk value or an ever high risk value.
Evidence is that the rank of risk measures varies according to market conditions. In particular, it
seems that in markets without volatility, historical simulation gives rise to the highest VaR
probably because it incorporates very older shocks. When an unusual market shift occurs, EWMA
VaR is the first one giving evidence of that, while the other measures either do not react at all or
react slowly. In very volatile market conditions, EWMA VaR produces the highest risk measure
while the other approaches, notably historical simulations, generate lower risk measures so that
they fail to react quickly to changed market conditions. So, if a very reactive risk measure is
required, it is likely that one will end up using EWMA VaR.
Also, contrarily to what one may think, a sophisticated approach like the filtered historical
simulation seems to generate risk measures very similar to those produced by the parametric
approach, which is undoubtedly the simplest method. In addition, it is important to point out that
the filtered approach also appears to be affected by the echo effect.

Relative VaR at 99%

0,00%
-1,00%
-2,00%
-3,00%
-4,00%
-5,00%
VaR 99% PAR 100D

VaR 99% HS 100D

VaR 99% EWMA(0,94) 100D

VaR 99% HS 500D

VaR 99% Filtered HS 100D EWMA

Relative VaR at 95%

0,00%
-0,50%
-1,00%
-1,50%
-2,00%
VaR 95% PAR 100D

VaR 95% HS 100D

VaR 95% EWMA(0,94) 100D

VaR 95% HS 500D

VaR 95% Filtered HS 100D EWMA