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Abstract
The financial concept of value-at-risk (VaR) plays an integral role in modern financial
risk management. VaR is used by many large financial institutions to measure the
riskiness of their holdings and determine safe levels of capital to hold. This paper will
explore the mathematics behind this fundamental concept. Specifically, the relevant
probability theory underlying VaR will be discussed as will some concepts from linear
algebra and applied mathematics that are useful in the computation of VaR. The paper
will conclude with a sample problem that illustrates how to go about finding the VaR for
a hypothetical portfolio.
I. Introduction
Value-at-Risk (VaR) gives the financial risk manager the worst expected loss under
average market conditions over a certain time interval at a given confidence level. In
other words, VaR gives the risk manager a sense of what he or she can expect to
potentially lose in a given time interval, assuming normal market conditions.
given by E[X] =
x p( x ) , where xi are the various values that X can take, and p(xi) is
i
i 1
The expected value can be thought of as a weighted average of the possible values that X
can take. When each value of X occurs with the same probability, the expected value
n
xi p( xi ) =
i 1
pxi =
i 1
1
n
x .
i
i 1
E[ i X i ] =
i 1
i 1
In addition to having a measure of the average value of a set of data, being able to
measure the spread, or variability, of a random variable is also important.
(x )
i
i 1
are the various values that X can take, and p(xi) is the probability of X taking the value xi.
When each value of X occurs with the same probability, the variance takes on the more
n
(x )
i
i 1
pi =
(x )
i
i 1
p=
1
n
(x
)2 .
i 1
1 n
( xi E[ X ])( yi E[Y ]) .
n i 1
Now that the covariance has been defined, the variance of a linear combination of
random variables can be discussed.
Definition 5: The variance of 1X1+2X2++nXn, when Xi are random variables, and
i , i {1,2,,n}, is given as follows:
n
Var( i X i ) =
i 1
i2Var (X i ) + 2 i jCov( X i , X j ) .
i 1
i j
Admittedly, this looks a bit ugly. When the example quantitative problem is solved, this
summation will be better elucidated. This is one calculation where techniques from
linear algebra prove invaluable.
Now that the expectation, variance, and covariance have been thoroughly discussed, the
topic of probability distributions can be given some attention. Probability distributions
are essential to VaR calculations. Take the expected value and variance of the portfolio
returns, and apply these to a probability distribution (a portfolio can be thought of as a
linear combination of assets, or random variables). Inferences as to the probabilistic
return characteristics of the portfolio, assuming it adheres to the distribution that was
chosen, can be made.
Thus far, random variables whose set of possible values was finite or countably infinite
have been considered. This is a discrete setting. In a continuous setting, random
variables whose set of possible values is uncountable are considered.
f ( x)dx .
Function of X. In other words, the probability that X is in the set B can be found by
integrating f over the set B.
Since X must always take a value in the reals (ie. X (-,)), the following logically
follows:
P[X (-,)] =
f ( x)dx = 1.
Also, any probability statement about X can be written in terms of f. For example, if
b
f ( x)dx .
a
f ( x)dx .
Recall, in the discrete setting the expected value of X was defined as follows:
n
E[X] =
x p( x ) .
i
i 1
E[X] =
xf ( x)dx .
Var(X) =
(x )
2
1
e ( x )
2
2 2
.
7
If X is normally distributed with mean and variance 2, we can create a new variable Z
that is also normally distributed and is termed the standard normal random variable.
Z=
1
(1) 2
e ( x 0 )
2 (1)2
1 z2 2
.
e
2
standardization.
Finally, the cumulative distribution function for the standard normal random variable
must be described. The CDF, denoted (x) , is denoted as follows:
a
(a ) =
1 y 2
e
dy = P[Z a]. This can be thought of as the area of the shaded
2
and Zb =
. Now apply
the cumulative distribution function for the standard normal random variable.
Zb
Za
1 y 2
e
dy = ( Z b ) - ( Za )
2
This covers the basic probability theory underlying VaR. Now, two methods from linear
algebra useful in the computation of VaR will be examined.
E[ X 1 ]
E[ X 2 ]
E[ X ] .
3
E[ X n ]
E[ X 1 ]
E[ X 2 ]
E[ X ]
3
E[ X n ]
E[ X ] , agreeing with
i
i 1
where i is the proportion of the portfolio invested in asset Xi. Assuming the expected
return of each asset and the proportion of the total portfolio invested in each asset is
known, the expected return of the overall portfolio can be determined. Using matrices is
useful computationally when dealing with a large portfolio of many assets. One simple
T
matrix operation (K U) is all that is needed to find the expected return of the total
portfolio.
n
2
i
Var (X ) + 2 Cov( X , X
i 1
).
i j
As one can imagine for a large portfolio (many Xi) this is a non-trivial calculation. Again,
matrices are usually the best way to proceed. In this case, the matrix used is the
Variance-Covariance Matrix, denoted .
10
11
21
= 31
n1
12 13 1n
22 23 2 n
32 33 3n .
n 2 n3
nn
1
2
n
Var( i X i ). Let K = 3 and =
i 1
n
n
11
21
31
n1
12 13 1n
22 23 2 n
32 33 3n .
n 2 n3
nn
Then Var( i X i ) = K K . Since this result is not very obvious, lets look at the 3
i 1
Var( i X i ) = K K = 1 2
i 1
11 12 13 1
3 21 22 23 2 .
31 32 33 3
i2Var (X i ) + 2 i j Cov( X i , X j )
i 1
i j
11
D = D
i
i 1
dollars. Assume the one-day return of Asset i is normally distributed with expected value
E[ri] and variance i2 . Also, the covariance between the 1-day returns of Assets i and j is
given by ij . Given this information, find the 1-day VaR at a confidence level of 5%.
Solution: First, determine the expected return and variance of the overall portfolio. The
first step in doing this is to calculate the weighting for each asset. The proportion of the
portfolio expected return attributable to Asset i is i =
Di
. These are the
D1 D2 ... DN
1
2
Now, let K = 3 and let U =
N
E[r1 ]
E[r2 ]
E[ r ] .
3
E[rN ]
random variables, where the random variables are the expected 1-day returns for each
asset, and the coefficients are the asset weighting factors.
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E[ X ] and the
i
i 1
i 1
matrix method for finding this expectation, we obtain the following result:
E[r1 ]
E[r2 ]
N E[r3 ] =
E[rN ]
E[rPortfolio] = E[ i ri ] = KTU = 1 2 3
i 1
E[r ] =
i
i 1
Next, we must calculate the variance of the total portfolio. In other words, we need to
calculate the variance of the linear combination of random variables. As was discussed
on page 5, the variance of the linear combination of random variables is given by
n
Var( i X i ) =
i 1
i2Var (X i ) + 2 i jCov( X i , X j ) .
i j
i 1
p2 = Var( i ri ) =
i 1
N
2
i
Var (r ) + 2 Cov(r , r )
i 1
i j
= i2 i2 + 2 i j ij
i 1
i j
1
2
2
To actually compute p , let K = 3 and =
N
12 12 13
21 22 23
2
31 32 3
N 1 N 2 N 3
1N
2N
3 N .
N2
13
p2 = Var( i ri ) = KTK = 1 2
i 1
12 12 13
21 22 23
N 31 32 32
N 1 N 2 N 3
1 N 1
2N 2
3 N 3 .
N2 N
Now that we have an expected value and variance for the overall portfolio return, we can
find the VaR. We assume that the portfolio return is normally distributed with mean p
and variance 2p , both of which are numbers we have calculated. Since we want the VaR
at a 5% confidence level, we are solving for the return such that a return worse than this
return occurs only 5% of the time. Mathematically, we are solving for r* such that
r*
1
p
( x p ) 2 2 2p
dx = 0.05.
14
Many mathematical software programs have a NORMINV function to solve for r*.
Solving for r* analytically is quite involved, and this would not be done in a real-world
r*
1
p
( x p ) 2 2 2p
dx = 0.05
holds.
In the unusual event that r* > 0, the VaR is not very useful. Recall, we found r* such
that the portfolio performs worse than r* only 5% of the time. But r* > 0, so essentially
we are stating that only 5% of the time will the portfolio earn us a positive return between
0 and r* or lose money. Therefore, if we obtain an r* > 0, it is a useless metric. We
should run a new VaR analysis with a lower confidence level until we obtain an r* < 0.
expected returns, variances, and covariances. Still, the point that a great deal of data is
needed before one can even approach calculating a portfolio VaR cannot be stressed
enough.
It is also important to note that VaR is a very versatile model. While this paper used a
normal distribution, practically any distribution can be implemented. This gives the risk
manager the ability to tailor a VaR model to the specific characteristics of the portfolio he
or she is dealing with.
Lastly, an interesting trend in risk management has been the movement toward
probability distributions that have fatter tails (ie. distributions that give greater
weighting to outlying, multi-sigma events). A major realization of the recent financial
crisis has been that financial returns do not always approximate a normal distribution or
some other benign distribution. Extreme events, often termed Black Swans, tend to
occur more frequently than such distributions would predict. Consequently, greater
emphasis has been placed on using distributions with fatter tails that give a larger
weighting to these extreme events.
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References
Benninga, Simon. 2000. Financial Modeling. 2nd Edition. Cambridge, MA: The MIT
Press.
Bodie, Zvi, A. Kane, and A.Marcus. 2008. Essentials of Investments. 7th Edition. New
York: McGraw-Hill Irwin.
The Gods Strike Back: A Special Report on Financial Risk. The Economist. 13
February 2010.
Ross, Sheldon. 2006. A First Course in Probability. 7th Edition. Upper Saddle River,
NY: Pearson Prentice Hall, Inc.
Strang, Gilbert. 2007. Computational Science and Engineering. Wellesley, MA:
Wellesley-Cambridge Press.
Taleb, Nicholas Nassim. 2007. The Black Swan. New York: Random House, Inc.
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