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1 Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No.
31.1 Measuring Market Risk
Session By
Ratan Gupta
Training For FRM
Part 2 Program
Reference: Kevin Dowd, Measuring Market Risk, 2nd Edition Ch 3
Historical VaR
A
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AIM: Calculate VaR using a historical simulation approach.
Ordered Loss Observation
If there are 10000 observations then, 5% tail would mean that there are 500
observation in the left tail
Since, in VaR we are interested in loss below a point, the VaR would be the
501
st
loss value (on the sorted data)
Parametric Estimation
B
3 Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No.
AIM: Calculate VaR using a parametric estimation approach assuming that the return
distribution is either normal or lognormal.
For Normal Distribution assumption, VaR is given as
Example: Assuming normal distribution, if the mean return is $10 Mn and
the standard deviation of the returns is $15 Mn. Compute the 95% VaR and
99% VaR.
For Log-Normal Distribution assumption, VaR is given as
Example: Assuming Log normal distribution, if the mean return is 10% and
the standard deviation of the returns is 15%. Compute the 95% VaR and
99% VaR. Assume portfolio value of $100 Mn
% =

)
Expected Loss
B
4 Copyright 2012 Knowledge Varsity | www.knowledgevarsity.com | Page No.
AIM: Calculate the expected shortfall given P/L or return data.
probability-weighted average of tail losses
Known as conditional VaR loss that you will face in excess of VaR
ES is average of tail VaRs
To Find, break the tail in n slice. Find the VaR of n-1 slice and take average
Coherent Risk Measures
C
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AIM: Define coherent risk measures.
VaR is not coherent risk measure
It doesnt adhere to Sub-additivity principle
Other three properties are monotonicity, positive homogeneity, translation
invariance
Monotonicity If expected value of Y is more than X, then risk of Y is more
than X
positive homogeneity If you double the portfolio value, the risk will be
doubled
translation invariance adding cash decreases the portfolio risk
Coherent Risk Measures
D
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AIM: Describe the method of estimating coherent risk measures by estimating quantiles
weighted average of the quantiles
No need to know the details of the weighting function
Multiply the quantile by weight and take the summation (or integrate)
Refer to the excel sheet and see how we have computed the risk for a given
weighting function below
In case of expected loss the weight function is simple, it gives a weight of 0
for all probability less than
Coherent Risk Measures
D
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What happens when the tail slices increases
Refer to table 3.4 from the book below
Source: Measuring Market Risk (2
nd
Edition) Kevin Dowd
Coherent Risk Measures
D
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Halving Error
Refer to table 3.5 from the book below
Source: Measuring Market Risk (2
nd
Edition) Kevin Dowd
estimating standard errors
E
9 Copyright 2012 Knowledge Varsity | www.knowledgevarsity.com | Page No.
AIM: Describe the method of estimating standard errors for estimators of coherent risk measures
Best is to compute the error of coherent risk measures
From the exam point of view we need to only understand and analyze the
process, no need to do in the exam
There are various methods to estimate the standard errors
After computation of standard error we compute the confidence interval of
VaR
We never know the true value of the risk measure
We are just trying to get a best estimate of the risk measure
In this class we will cover the approach given in the book
QQ plots
F
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AIM: Describe the use of QQ plots for identifying the distribution of data.
Inspect the data
QQ plot is used to check if the data fits the hypothesized distribution or not
Source: Measuring Market Risk (2
nd
Edition) Kevin Dowd
QQ plots
F
11 Copyright 2012 Knowledge Varsity | www.knowledgevarsity.com | Page No.
AIM: Describe the use of QQ plots for identifying the distribution of data.
Source: Measuring Market Risk (2
nd
Edition) Kevin Dowd