Financial Risk Management

Portfolio Risk, Analytical Methods

Following P. Jorion,
Value at Risk, McGraw-Hill, Chapter 7

Daniel HERLEMONT

Portfolio of Random Variables

N
Y = wi X i = wT X
i =1
N
E (Y ) = p = w E ( X ) = w X = wi i
T T

i =1
N N
2 (Y ) = wT w = wi ij w j
i =1 j =1

VAR p = W wT w
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 Diversified VAR

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VAR and correlations

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 Exercise

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VAR Tools

Marginal VAR

Incremental VAR

Component VAR

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 Marginal VaR

How risk sensitive is my portfolio to increase in size of each

position?
- calculate VaR for the entire portfolio VaRP=X
- increase position A by one unit (say 1% of the portfolio)
- calculate VaR of the new portfolio: VaRPa= Y
- incremental risk contribution to the portfolio by A: Z = X-Y

i.e. Marginal VaR of A is Z = X-Y

Marginal VaR can be Negative; what does this mean...?

Daniel HERLEMONT

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 Relation to beta and CAPM

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Incremental VaR

Risk contribution of each position in my portfolio.

- calculate VaR for the entire portfolio VaRP= X
- remove A from the portfolio
- calculate VaR of the portfolio without A: VaRP-A= Y
- Risk contribution to the portfolio by A: Z = X-Y

i.e. Incremental VaR of A is Z = X-Y

Incremental VaR can be Negative; what does this mean...?

Daniel HERLEMONT

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 Example

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Component VAR

Objective: to get a risk decomposition of the portfolio

Taking individual VAR is not useful since it ignore
diversification
Rather, the component VAR defined as

indicates how the portfolio would change

(approximately) if the component is deleted from
the portfolio

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VaR decomposition

VaR

Incremental VaR
Marginal VaR

Portfolio VaR
Component VaR

100 Position in asset A

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 Summary

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Example of VaR decomposition

Currency Position Individual Marginal Component Contribution

VaR VaR VaR to VaR in %

CAD $2M $165,000 0.0528 $105,630 41%

EUR $1M $198,000 0.1521 $152,108 59%

Total $3M

Undiversified $363K

Diversified $257,738 100%

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 Barings Example

Long $7.7B Nikkei futures

Short of $16B JGB futures
NK=5.83%, JGB=1.18%, =11.4%

P2 = 7.7 2 0.05832 + 16 2 0.01182 + 2 7.7 16 0.0583 0.114 0.0118

VaR95%=1.65P = $835M
VaR99%=2.33 P=$1.18B
Actual loss was $1.3B

Daniel HERLEMONT

Baring's Risk

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 Simplifying the correlation Matrix

With 10 assets, the covariance matrix need to

estimate 10*11/2=55 elements. With 100 assets, we
need to estimate 5050 elements ...

lead to estimation errors

need for simplification and robustness
 One Factor (Market) Model - Sharpe / CAPM
 Multi Factors Model - APT, Ross & Roll,
BARRA, ...
 Implicit Factors (Principal Component Analysis)

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PCA on US Bonds

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