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Some Traditional Risk Measures

The document discusses several traditional risk measures used in finance including the Greeks, modified duration, and value at risk (VaR). The Greeks measure the sensitivity of an option's price to changes in underlying variables like price, volatility, time, and interest rates. Modified duration measures interest rate risk for bonds. VaR uses the variance-covariance approach to estimate potential portfolio losses over a given time period at a certain confidence level. It involves estimating risks and correlations, determining position weights, and using portfolio math to calculate overall risk.

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Deniz Onal
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39 views17 pages

Some Traditional Risk Measures

The document discusses several traditional risk measures used in finance including the Greeks, modified duration, and value at risk (VaR). The Greeks measure the sensitivity of an option's price to changes in underlying variables like price, volatility, time, and interest rates. Modified duration measures interest rate risk for bonds. VaR uses the variance-covariance approach to estimate potential portfolio losses over a given time period at a certain confidence level. It involves estimating risks and correlations, determining position weights, and using portfolio math to calculate overall risk.

Uploaded by

Deniz Onal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Some traditional risk measures

The Greeks
2

C
• DELTA 
S
The Greeks 
C
• THETA  (T  t )
• When dealing with derivatives
use arbitrage-free pricing C
models

• VEGA 
• Sensitivity ratios tell how much
one can expect to lose from a C
change in price underlying, 
volatility underlying... • RHO r
 ²C

• GAMMA S ²

• C= option price
• S = price of underlying
• r = interest rate
3

The Greeks (continued)

• Advantages:
 State-of-the-art option pricing can be used
 More precise than traditional thumb rules
• Disadvantages:
 Often not intuitive → danger of using quantitative results
mechanically, without feel for the markets
 Greeks only work for small changes in the risk factor, and
can therefore not be used to evaluate riskiness of positions
in case of a crash
 No aggregate measure of risk, but several measures w.r.t.
different risk measures
Some traditional risk measures

Modified duration
5

Modified duration

• A popular interest rate risk measure is


Modified duration:

MD = -dP/P = 1 ΣiCF (1 + y)-i


dy 1 + y ΣCF (1 + y)-i

• The MD approximates the percentage price change for a


given change in yield

dP = -MDdy
P
6

Modified duration (continued)

• Advantages:
 Intuitive
 Easy to calculate (Excel function)
 MD of portfolio is weighted average of MD’s of individual
bonds
• Disadvantages:
 Interest rate movements are the sole source of risk
 All bonds are assumed to be perfectly correlated
 Easy calculation is no longer important advantage
 MD only work for small yield changes in the risk factor
Value at risk
8

Variance/Covariance approach

• The var/covar approach is widely used


• It is the approach used by JP Morgan’s RiskMetrics
• Principal difference to historical simulation:
The Var/Covar approach assumes the portfolio returns to be
distributed normally
• Why the normality assumption?
 Once VaR calculated for particular confidence level and
holding period, it becomes very simple to calculate VaR for
other confidence levels and/or holding periods
 VaR becomes more comparable accross institutions
9

Variance/Covariance approach (continued)

• Example:
 Position worth $1000.000 in 30-year bond
⇨ Mean of return = 7%
⇨ Volatility of return = 15%
⇨ Holding period of one year
 99% confidence interval (one-tailed), given 1-year holding
period?
⇨ 7% - 2,33 x 15% = -27,95%
⇨ 1% chance that returns will fall below -27,95%
 Translate into dollar terms
⇨ -27,95% x $1000.000 = -$297.500
10

Variance/Covariance approach (continued)

 Losses over a holding period of one year will therefore


exceed $297.500 only in 1% of all cases
1-year, 99% VaR is $297.500
 Assume now different holding period 30 days
⇨ A year has 252 trading days
σ30-days = σ1-year x √ 30/252

⇨ Relevant volatility is now 5,175%


μ30-days = μ30-days x (30/252)

⇨Relevant expected return is now 0,833%


11

Variance/Covariance approach (continued)

 99% confidence interval (one-tailed), given 30-day holding


period?
⇨ 0,833% - 2,33 x 5,175% = -11,225%
⇨ 1% chance that returns will fall below -11,225%
⇨ Losses can exceed $112.250 only in 1% of all cases
30-day, 99% VaR is $112.250
 Now change confidence interval to 95%
⇨ Cut-off point for standard normal distribution is -1,65
⇨ 0,833% - 1,65 x 5,175% = -0,077%
⇨ 1% chance that returns will fall below -0,077%
⇨ Losses can exceed $77.000 only in 5% of all cases
30-day, 95% VaR is $77.000
12

Variance/Covariance approach (continued)

• Step 1: Estimate Variance/Covariance matrix


 If many securities, obtaining volatilities of all securities and
correlations of each security with all other instrument, is
infeasible
⇨ Solution : mapping (bucketing)
⇨ Approximate the instruments we hold as
combinations of standard building blocks
• Core currencies
• Stock indices
• Cash flow of a limited number of specified maturities,
in a given currency
• Stabdardised commodity future contracts
13

Variance/Covariance approach (continued)

 VaR of Portfolio holding only the standard building blocks,


approximates the ‘true’ VaR
 Example: Bond paying semi-annual coupons, maturing in 5
years and with a duration of 4,25
⇨ Cash flow mapping:
Each coupon payment as well as the principal payment are
mapped according to its individual maturity date (e.g. first
coupon payment is mapped to the 6-month interest rate
exposure)
⇨ Duration method:
Part of the bond is mapped to the 4-year interest rate exposure
bucket and the rest to the 5-year bucket, such that the average
duration is 4,25
14

Variance/Covariance approach (continued)

 Now we can use the variance/covariance matrix of the


standard building blocks
 E.g.
Security Stock A Stock B
Stock A 0,0625 0,00375
Stock B 0,00375 0,0225

• Step 2: Aggregate portfolio risk


 Before summarising total portfolio risk using “portfolio
maths”, we need to determine the weights
15

Variance/Covariance approach (continued)

 Assume we hold worth $5.000.000 in both stocks


 The security weights (WA, WB) are then both 0,5
 The portfolio variance is therefore given by:

2 2 2 2 2
σp = wAσA + wBσB + 2wAwBσAB
2
σp = 0,52(0,25)2 + 0,52(0,15)2 + 2(0,5)(0,5)
(0,00375)
2

σp = 0,023125

 The portfolio volatility is the square root:


σp = 0,152069
16

Variance/Covariance approach (continued)

• Step 3: Daily VaR for 99% confidence interval?


 For 99% confidence level, standard normal deviate = 2,33
 Holding period = 1/252, assuming 252 trading days a year

VaR = 2,33 x 0,152069 x √1/252 x


$10.000.000
VaR = $223.201
17

Variance/Covariance approach (continued)

• Advantages:
 Intuitive
 One VaR calculation is enough for determining VaR over
different holding periods and for other confidence levels
 Easy to implement
 Can handle large portions (mapping procedure)
• Disadvantages:
 Returns are assumed normal, but often fat tails in reality
(use of other distributions)
 Returns are assumed linear in underlying risks (for options
use delta-gamma approximation methods or change
method and use historical simulation or Monte-Carlo)
 Model risk

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