Value-at-Risk: An Overview of Analytical

VaR
by Romain Berry
J.P. Morgan Investment Analytics and Consulting
romain.p.berry@jpmorgan.com
In the last issue, we discussed the principles of a sound risk management function to
efficiently manage and monitor the financial risks within an organization. To many risk
managers, the heart of a robust risk management department lies in risk measurement
through various complex mathematical models. But even one who is a strong believer in
quantitative risk management would have to admit that a risk management function that
heavily relies on these sophisticated models cannot add value beyond the limits of
understanding and expertise that the managers themselves have towards these very
models. Risk managers relying exclusively on models are exposing their organization to
events similar to that of the sub-prime crisis, whereby some extremely complex models
failed to accurately estimate the probability of default of the most senior tranches of
CDOs1. Irrespective of how you put it, there is some sort of human or operational risk in
every team within any given organization. Models are valuable tools but merely represent
a means to manage the financial risks of an organization.
This article aims at giving an overview of one of the most widespread models in use in
most of risk management departments across the financial industry: Value-at-Risk (or
VaR)2. VaR calculates the worst expected loss over a given horizon at a given confidence
level under normal market conditions. VaR estimates can be calculated for various types
of risk: market, credit, operational, etc. We will only focus on market risk in this article.
Market risk arises from mismatched positions in a portfolio that is marked-to-market
periodically (generally daily) based on uncertain movements in prices, rates, volatilities
and other relevant market parameters. In such a context, VaR provides a single number
summarizing the organizations exposure to market risk and the likelihood of an
unfavorable move. There are mainly three designated methodologies to compute VaR:
Analytical (also called Parametric), Historical Simulations, and Monte Carlo
Simulations. For now, we will focus only on the Analytical form of VaR. The two other
methodologies will be treated separately in the upcoming issues of this newsletter. Part 1
of this article defines what VaR is and what it is not, and describes the main parameters.
Then, in Part 2, we mathematically express VaR, work through a few examples and play
with varying the parameters. Part 3 and 4 briefly touch upon two critical but complex
steps to computing VaR: mapping positions to risk factors and selecting the volatility
model of a portfolio. Finally, in Part 5, we discuss the pros and cons of Analytical VaR.
Part 1: Definition of Analytical VaR
VaR is a predictive (ex-ante) tool used to prevent portfolio managers from exceeding risk
tolerances that have been developed in the portfolio policies. It can be measured at the

portfolio, sector, asset class, and security level. Multiple VaR methodologies are available
and each has its own benefits and drawbacks. To illustrate, suppose a $100 million
portfolio has a monthly VaR of $8.3 million with a 99% confidence level. VaR simply
means that there is a 1% chance for losses greater than $8.3 million in any given month
of a defined holding period under normal market conditions.
It is worth noting that VaR is an estimate, not a uniquely defined value. Moreover, the
trading positions under review are fixed for the period in question. Finally, VaR does not
address the distribution of potential losses on those rare occasions when the VaR estimate
is exceeded. We should also bear in mind these constraints when using VaR. The ease of
using VaR is also its pitfall. VaR summarizes within one number the risk exposure of a
portfolio. But it is valid only under a set of assumptions that should always be kept in
mind when handling VaR.
VaR involves two arbitrarily chosen parameters: the holding period and the confidence
level. The holding period corresponds to the horizon of the risk analysis. In other words,
when computing a daily VaR, we are interested in estimating the worst expected loss that
may occur by the end of the next trading day at a certain confidence level under normal
market conditions. The usual holding periods are one day or one month. The holding
period can depend on the funds investment and/or reporting horizons, and/or on the local
regulatory requirements. The confidence level is intuitively a reliability measure that
expresses the accuracy of the result. The higher the confidence level, the more likely we
expect VaR to approach its true value or to be within a pre-specified interval. It is
therefore no surprise that most regulators require a 95% or 99% confidence interval to
compute VaR.
Part 2: Formalization and Applications
Analytical VaR is also called Parametric VaR because one of its fundamental assumptions
is that the return distribution belongs to a family of parametric distributions such as the
normal or the lognormal distributions. Analytical VaR can simply be expressed as:
(1)
where:

VaR is the estimated VaR at the confidence level 100 (1 - )%.

x is the left-tail percentile of a normal distribution
. x is described in
the expression
where R is the expected return. In order for VaR to be
meaningful, we generally choose a confidence level of 95% or 99%. x is
generally negative.
P is the marked-to-market value of the portfolio.

The Central Limit Theorem states that the sum of a large number of independent and
identically distributed random variables will be approximately normally distributed (i.e.,
following a Gaussian distribution, or bell-shaped curve) if the random variables have a
finite variance. But even if we have a large enough sample of historical returns, is it
realistic to assume that the returns of any given fund follow a normal distribution? Thus,

we need to associate the return distribution to a standard normal distribution which has a
zero mean and a standard deviation of one. Using a standard normal distribution enables
us to replace x by z through the following permutation:
(2)
which yields:
(3)
z is the left-tail percentile of a standard normal distribution. Consequently, we can rewrite (1) as:
(4)
Example 1 Analytical VaR of a single asset
Suppose we want to calculate the Analytical VaR at a 95% confidence level and over a
holding period of 1 day for an asset in which we have invested $1 million. We have
estimated3 (mean) and (standard deviation) to be 0.3% and 3% respectively. The
Analytical VaR of that asset would be:

This means that there is a 5% chance that this asset may lose at least $46,347 at the end
of the next trading day under normal market conditions.
Example 2 Conversion of the confidence level
Assume now that we are interested in a 99% Analytical VaR of the same asset over the
same one-day holding period. The corresponding VaR would simply be:

There is a 1% chance that this asset may experience a loss of at least $66,789 at the end
of the next trading day. As you can see, the higher the confidence level, the higher the
VaR as we travel downwards along the tail of the distribution (further left on the x-axis).
Example 3 Conversion of the holding period
If we want to calculate a one-month (21 trading days on average) VaR of that asset using
the same inputs, we can simply apply the square root of the time5:
(5)

Applying this rule to our examples above yields the following VaR for the two
confidence levels:

Example 4 Analytical VaR of a portfolio of two assets

Let us assume now that we have a portfolio worth $100 million that is equally invested in
two distinct assets. One of the main reasons to invest in two different assets would be to
diversify the risk of the portfolio. Therefore, the main underlying question here is how
one asset would behave if the other asset were to move against us. In other words, how
will the correlation between these two assets affect the VaR of the portfolio? As we
aggregate one level up the calculation of Analytical VaR, we replace in (4) the mean of
the asset by the weighted mean of the portfolio, P and the standard deviation (or
volatility) of the asset by the volatility of the portfolio, P. The volatility of a portfolio
composed of two assets is given by:
(6)
where

w1 is the weighting of the first asset

w2 is the weighting of the second asset
1 is the standard deviation or volatility of the first asset
2 is the standard deviation or volatility of the second asset
1,2is the correlation coefficient between the two assets

And (4) can be re-written as:

(7)
Let us assume that we want to calculate Analytical VaR at a 95% confidence level over a
one-day horizon on a portfolio composed of two assets with the following assumptions:

P = $100 million
w1 = w2 = 50%6
1 = 0.3%
1 = 3%
2 = 0.5%
2 = 5%

1,2 = 30%
(8)

Example 5 Analytical VaR of a portfolio composed of n assets

From the previous example, we can generalize these calculations to a portfolio composed
of n assets. In order to keep the mathematical formulation handy, we use matrix notation
and can re-write the volatility of the portfolio as:

(9)

where:

w is the vector of the weights of the n assets

w is the transpose vector of w
is the covariance matrix of the n assets

Practically, we could design a

spreadsheet in Excel (Exhibit
1) to calculate Analytical VaR
on the portfolio in Example 4.
The cells in grey are the input
cells.
It is easy from there to expand
the calculation to a portfolio of
n assets. But be aware that you
will soon reach the limits of
Excel as we will have to
calculate n(n-1)/2 terms for
your covariance matrix.
Part 3: Risk Mapping
In order to cope with an
increasing covariance matrix
each time you diversify your
portfolio further, we can map
each security of the portfolio to
common fundamental risk
factors and base our
calculations of Analytical VaR
on

Exhibit 1: Excel Spreadsheet to calculate

Analytical VaR for a portfolio of two assets
(click to enlarge)

these risk factors. This process is called reverse engineering and aims at reducing the size
of the covariance matrix and speeding up the computational time of transposing and
multiplying matrices. We generally consider four main risk factors: Spot FX, Equity,
Zero-Coupon Bonds and Futures/Forward. The complexity of this process goes beyond
the scope of this overview of Analytical VaR and will need to be treated separately in a
future article.
Part 4: Volatility Models
We can guess from the various expressions of Analytical VaR we have used that its main
driver is the expected volatility (of the asset or the portfolio) since we multiply it by a
constant factor greater than 1 (1.6449 for a 95% VaR, for instance) as opposed to the
expected mean, which is simply added to the expected volatility. Hence, if we have used
historical data to derive the expected volatility, we could consider how todays volatility
is positively correlated with yesterdays volatility. In that case, we may try to estimate the
conditional volatility of the asset or the portfolio. The two most common volatility
models used to compute VaR are the Exponential Weighted Moving Average (EWMA)
and the Generalized Autoregressive Conditional Heteroscedasticity (GARCH). Again, in
order to be exhaustive on this very important part in computing VaR, we will discuss
these models in a future article.
Part 5: Advantages and Disadvantages of Analytical VaR
Analytical VaR is the simplest methodology to compute VaR and is rather easy to
implement for a fund. The input data is rather limited, and since there are no simulations
involved, the computation time is minimal. Its simplicity is also its main drawback. First,
Analytical VaR assumes not only that the historical returns follow a normal
distribution, but also that the changes in price of the assets included in the portfolio
follow a normal distribution. And this very rarely survives the test of reality. Second,
Analytical VaR does not cope very well with securities that have a non-linear payoff
distribution like options or mortgage-backed securities. Finally, if our historical series
exhibits heavy tails, then computing Analytical VaR using a normal distribution will
underestimate VaR at high confidence levels and overestimate VaR at low
confidence levels.
Conclusion
As we have demonstrated, Analytical VaR is easy to implement as long as we follow
these steps. First, we need to collect historical data on each security in the portfolio (we
advise using at least one year of historical data except if one security has experienced
high volatility, which would suggest a shorter period of time). Second, if the portfolio has
a large number of underlying positions, then we would need to map them against a more

manageable set of risk factors. Third, we need to calculate the historical parameters
(mean, standard deviation, etc.) and need to estimate the expected prices, volatilities and
correlations. Finally we apply (7) to find the Analytical VaR estimate of the portfolio.
As always when building a model, it is important to make sure that it has been reviewed,
fully tested and approved, that a User Guide (including any potential code) has been
documented and will be updated if necessary, that a training has been designed and
delivered to the members of the risk management team and to the recipients of the
outputs of the risk management function, and finally that a capable person has been
allocated the oversight of the model, its current use, and regular refinement.

CDO stands for Collaterized Debt Obligation. These instruments repackage a portfolio
of average- or poor-quality debt into high-quality debt (generally rated AAA) by splitting
a portfolio of corporate bonds or bank loans into four classes of securities, called
tranches.
2
Pronounced VahR.
3
Note that these parameters have to be estimated. They are not the historical parameters
derived from the series.
4
Note that z is to be read in the statistical table of a standard normal distribution.
5
This rule stems from the fact that the sum of n consecutive one-day log returns is the nday log return and the standard deviation of n-day returns is n standard deviation of
one-day returns.
6
These weights correspond to the weights of the two assets at the end of the holding
period. Because of market movements, there is little likelihood that they will be the same
as the weights at the beginning of the holding period.

An Overview of Value-at-Risk:
Part II - Historical Simulations
VaR
By Romain Berry
J.P. Morgan Investment Analytics and Consulting
romain.p.berry@jpmorgan.com
This article is the third in a series of articles exploring risk management for
institutional investors.
In the previous issue, we looked at Analytical Value-at-Risk, whose cornerstone is
the Variance-Covariance matrix. In this article, we continue to explore VaR as an
indicator to measure the market risk of a portfolio of financial instruments, but we

touch on a very different methodology.

We indicated in the previous article that the main benefits of Analytical VaR were
that it requires very few parameters, is easy to implement and is quick to run
computations (with an appropriate mapping of the risk factors). Its main drawbacks
lie in the significant (and inconsistent across asset classes and markets) assumption
that price changes in the financial markets follow a normal distribution, and that this
methodology may be computer-intensive since we need to calculate the n(n-1)/2
terms of the Variance-Covariance matrix (in the case where we do not proceed to a
risk mapping of the various instruments that composed the portfolio). With the
increasing power of our computers, the second limitation will barely force you to
move away from spreadsheets to programming. But the first assumption in the case
of a portfolio containing a non-negligible portion of derivatives (minimum 10%15% depending on the complexity and exposure or leverage) may result in the
Analytical VaR being seriously underestimated because these derivatives have nonlinear payoffs.
One solution to circumvent that theoretical constraint is merely to work only with
the empirical distribution of the returns to arrive at Historical Simulations VaR.
Indeed, is it not more logical to work with the empirical distribution that captures
the actual behavior of the portfolio and encompasses all the correlations between the
assets composing the portfolio? The answer to this question is not so clear-cut.
Computing VaR using Historical Simulations seems more intuitive initially but has
its own pitfalls as we will see. But first, how do we compute VaR using Historical
Simulations?
Historical Simulations VaR Methodology
The fundamental assumption of the Historical Simulations methodology is that you
look back at the past performance of your portfolio and make the assumption there
is no escape from making assumptions with VaR modeling that the past is a good
indicator of the near-future or, in other words, that the recent past will reproduce
itself in the near-future. As you might guess, this assumption will reach its limits for
instruments trading in very volatile markets or during troubled times as we have
experienced this year.
The below algorithm illustrates the straightforwardness of this methodology. It is
called Full Valuation because we will re-price the asset or the portfolio after every
run. This differs from a Local Valuation method in which we only use the
information about the initial price and the exposure at the origin to deduce VaR.
Step 1 Calculate the returns (or price changes) of all the assets in the portfolio
between each time interval.
The first step lies in setting the time interval and then calculating the returns of each

asset between two successive periods of time. Generally, we use a daily horizon to
calculate the returns, but we could use monthly returns if we were to compute the
VaR of a portfolio invested in alternative investments (Hedge Funds, Private Equity,
Venture Capital and Real Estate) where the reporting period is either monthly or
quarterly. Historical Simulations VaR requires a long history of returns in order to
get a meaningful VaR. Indeed, computing a VaR on a portfolio of Hedge Funds with
only a year of return history will not provide a good VaR estimate.
Step 2 Apply the price changes calculated to the current mark-to-market value of
the assets and re-value your portfolio.
Once we have calculated the returns of all the assets from today back to the first day
of the period of time that is being considered let us assume one year comprised of
265 days we now consider that these returns may occur tomorrow with the same
likelihood. For instance, we start by looking at the returns of every asset yesterday
and apply these returns to the value of these assets today. That gives us new values
for all these assets and consequently a new value of the portfolio. Then, we go back
in time by one more time interval to two days ago. We take the returns that have
been calculated for every asset on that day and assume that those returns may occur
tomorrow with the same likelihood as the returns that occurred yesterday. We revalue every asset with these new price changes and then the portfolio itself. And we
continue until we have reached the beginning of the period. In this example, we will
have had 264 simulations.
Step 3 Sort the series of the portfolio-simulated P&L from the lowest to the highest
value.
After applying these price changes to the assets 264 times, we end up with 264
simulated values for the portfolio and thus P&Ls. Since VaR calculates the worst
expected loss over a given horizon at a given confidence level under normal market
conditions, we need to sort these 264 values from the lowest to the highest as VaR
focuses on the tail of the distribution.
Step 4 Read the simulated value that corresponds to the desired confidence level.
The last step is to determine the confidence level we are interested in let us choose
99% for this example. One can read the corresponding value in the series of the
sorted simulated P&Ls of the portfolio at the desired confidence level and then take
it away from the mean of the series of simulated P&Ls. In other words, the VaR at
99% confidence level is the mean of the simulated P&Ls minus the 1% lowest value
in the series of the simulated values. This can be formulated as follows:
(1)

where:

VaR1- is the estimated VaR at the confidence level 100 (1 - )%

(R) is the mean of the series of simulated returns or P&Ls of the portfolio
R is the th worst return of the series of simulated P&Ls of the portfolio or,
in other words, the return of the series of simulated P&Ls that corresponds to
the level of significance

We may need to proceed to some interpolation since there will be no chance to get a
value at 99% in our example. Indeed, if we use 265 days, each return calculated at
every time interval will have a weight of 1/264 = 0.00379. If we want to look at the
value that has a cumulative weight of 99%, we will see that there is no value that
matches exactly 1% (since we have divided the series into 264 time intervals and not
a multiple of 100). Considering that there is very little chance that the tail of the
empirical distribution is linear, proceeding to a linear interpolation to get the 99%
VaR between the two successive time intervals that surround the 99th percentile will
result in an estimation of the actual VaR. This would be a pity considering we did all
that we could to use the empirical distribution of returns, wouldnt it? Nevertheless,
even a linear interpolation may give you a good estimate of your VaR. For those
who are more eager to obtain the exact VaR, the Extreme Value Theory (EVT) could
be the right tool for you. We will explain in another article how to use EVT when
computing VaR. It is rather mathematically demanding and would require us to
spend more time to explain this method.
Applications of Historical Simulations VaR
Let us compute VaR using historical simulations for one asset and then for a
portfolio of assets to illustrate the algorithm.
Example 1 Historical Simulations VaR for one asset
The first step is to calculate the return of the asset price between each time interval.
This is done in column D in Table 1. Then we create a column of simulated prices
based on the current market value of the asset (1,000,000 as shown in cell C3) and
each return which this asset has experienced over the period under consideration.
Thus, we have 100 x (-1.93%) =
-19,313.95. In Step 3, we simply sort all the simulated values of the asset (based on
the past returns). Finally, in Step 4, we read the simulated value in column G which
corresponds to the 1% worst loss. As there is no value that corresponds to 99%, we
interpolate the surrounding values around 99.24% and 98.86%. That gives us
-54,711.55.
This number does not take into account the mean, which is 1,033.21. As the 99%
VaR is the distance from the mean of the first percentile (1% worst loss), we need to
subtract the number we just calculated from the mean to obtain the actual 99% VaR.

In this example, the VaR of this asset is thus 1,033.21 (-54,711.55) = 55,744.76. In
order to express VaR in percentage, we can divide the 99% VaR amount by the
current value of the asset (1,000,000), which yields 5.57%.
Table 1 - Calculating Historical Simulations VaR for one asset

Asset Price

Histogram of Returns

Example 2 - Historical Simulations VaR for one portfolio

Computing VaR on one asset is relatively easy, but how do the historical simulations
account for any correlations between assets if the portfolio holds more than one
asset? The answer is also simple: correlations are already embedded in the price
changes of the assets. Therefore, there is no need to calculate a Variance-Covariance
matrix when running historical simulations. Let us look at another example with a
portfolio composed of two assets.
Table 2 - Calculating Historical Simulations VaR for a portfolio of two assets

Portfolio Unit Price

Histogram of Returns

As you can see, we simply add a couple of columns to replicate the intermediary
steps for the second asset. In this example, each asset represents 50% of the
portfolio. After each run, we re-value the portfolio by simply adding up the
simulated P&L of each asset. This gives us the simulated P&Ls for the portfolio
(column J).
This straightforward step of simply re-composing the portfolio after every run is one
of the reasons behind the popularity of this methodology. Indeed, we do not need to
handle sizeable Variance-Covariance matrices. We apply the calculated returns of
every asset to their current price and re-value the portfolio.
As we have noted, correlations are embedded in the price changes. In this example,
the 99% VaR of the first asset is 55,744.76 (or 5.57%) and the 99% VaR of the
second asset is 54,209.71 (or 5.42%). We know that VaR is a sub-additive risk
measure if we add the VaR of two assets, we will not get the VaR of the portfolio.
In this case, the 99% VaR of the portfolio only represents 3.67% of the current
marked-to-market value of the portfolio. That difference represents the
diversification effect. Having a portfolio invested in these two assets makes the risk
lower than investing in any of these two assets solely. The reason is that the gains on
one asset sometimes offset the losses on the other asset (rows 10, 12, 13, 17-20, 23,

26-28, 30, 32 in Table 2). Over the 265 days, this happened 127 times with different
magnitude. But in the end, this benefited the overall risk profile of the portfolio as
the 99% VaR of the portfolio is only 3.67%.
Advantages of Historical Simulations VaR
Computing VaR using the Historical Simulations methodology has several
advantages. First, there is no need to formulate any assumption about the return
distribution of the assets in the portfolio. Second, there is also no need to estimate
the volatilities and correlations between the various assets. Indeed, as we showed
with these two simple examples, they are implicitly captured by the actual daily
realizations of the assets. Third, the fat tails of the distribution and other extreme
events are captured as long as they are contained in the dataset. Fourth, the
aggregation across markets is straightforward.
Disadvantages of Historical Simulations VaR
The Historical Simulations VaR methodology may be very intuitive and easy to
understand, but it still has a few drawbacks. First, it relies completely on a particular
historical dataset and its idiosyncrasies. For instance, if we run a Historical
Simulations VaR in a bull market, VaR may be underestimated. Similarly, if we run a
Historical Simulations VaR just after a crash, the falling returns which the portfolio
has experienced recently may distort VaR. Second, it cannot accommodate changes
in the market structure, such as the introduction of the Euro in January 1999. Third,
this methodology may not always be computationally efficient when the portfolio
contains complex securities or a very large number of instruments. Mapping the
instruments to fundamental risk factors is the most efficient way to reduce the
computational time to calculate VaR by preserving the behavior of the portfolio
almost intact. Fourth, Historical Simulations VaR cannot handle sensitivity analyses
easily.
Lastly, a minimum of history is required to use this methodology. Using a period of
time that is too short (less than 3-6 months of daily returns) may lead to a biased and
inaccurate estimation of VaR. As a rule of thumb, we should utilize at least four
years of data in order to run 1,000 historical simulations. That said, round numbers
like 1,000 may have absolutely no relevance whatsoever to your exact portfolio.
Security prices, like commodities, move through economic cycles; for example,
natural gas prices are usually more volatile in the winter than in the summer.
Depending on the composition of the portfolio and on the objectives you are
attempting to achieve when computing VaR, you may need to think like an
economist in addition to a risk manager in order to take into account the various
idiosyncrasies of each instrument and market. Also, bear in mind that VaR estimates
need to rely on a stable set of assumptions in order to keep a consistent and
comparable meaning when they are monitored over a certain period of time.

In order to increase the accuracy of Historical Simulations VaR, one can also decide
to weight more heavily the recent observations compared to the furthest since the
latter may not give much information about where the prices would go today. We
will cover these more advanced VaR models in another article.
Conclusion
Despite these disadvantages, many financial institutions have chosen historical
simulations as their favored methodology to compute VaR. To many, working with
the actual empirical distribution is the real deal.
However, obtaining an accurate and reliable VaR estimate has little value without a
proper back testing and stress testing program. VaR is simply a number whose value
relies on a sound methodology, a set of realistic assumptions and a rigorous
discipline when conducting the exercise. The real benefit of VaR lies in its essential
property of capturing with one single number the risk profile of a complex or
diversified portfolio. VaR remains a tool that should be validated through successive
reconciliation with realized P&Ls (back testing) and used to gain insight into what
would happen to the portfolio if one or more assets would move adversely to the
investment strategy (stress testing).

An Overview of Value-at-Risk: Part III

Monte Carlo Simulations VaR
by Romain Berry
J.P. Morgan Investment Analytics & Consulting
romain.p.berry@jpmorgan.com
This article is the fourth in a series of articles exploring risk management for
institutional investors.
The last (and most complex) of the three main methodologies used to compute the
Value-at-Risk (VaR) of a portfolio of financial instruments employs Monte Carlo
Simulations. Monte Carlo Simulations correspond to an algorithm that generates
random numbers that are used to compute a formula that does not have a closed
(analytical) form this means that we need to proceed to some trial and error in
picking up random numbers/events and assess what the formula yields to
approximate the solution. Drawing random numbers over a large number of times (a
few hundred to a few million depending on the problem at stake) will give a good
indication of what the output of the formula should be. It is believed actually that the

name of this method stems from the fact that the uncle of one of the researchers (the
Polish mathematician Stanislaw Ulam) who popularized this algorithm used to
gamble in the Monte Carlo casino and/or that the randomness involved in this
recurring methodology can be compared to the game of roulette.
In this article, we present the algorithm, and apply it to compute the VaR for a
sample stock. We also discuss the pros and cons of the Monte Carlo Simulations
methodology compared to Analytical VaR and Historical Simulations VaR.

Methodology
Computing VaR with Monte Carlo Simulations follows a similar algorithm to the
one we used for Historical Simulations in our previous issue. The main difference
lies in the first step of the algorithm instead of picking up a return (or a price) in
the historical series of the asset and assuming that this return (or price) can re-occur
in the next time interval, we generate a random number that will be used to estimate
the return (or price) of the asset at the end of the analysis horizon.
Step 1 Determine the length T of the analysis horizon and divide it equally into
a large number N of small time increments t (i.e. t = T/N).
For illustration, we will compute a monthly VaR consisting of twenty-two trading
days. Therefore N = 22 days and t = 1 day. In order to calculate daily VaR, one
may divide each day per the number of minutes or seconds comprised in one day
the more, the merrier. The main guideline here is to ensure that t is large enough to
approximate the continuous pricing we find in the financial markets. This process is
called discretization, whereby we approximate a continuous phenomenon by a large
number of discrete intervals.
Step 2 Draw a random number from a random number generator and update
the price of the asset at the end of the first time increment.
It is possible to generate random returns or prices. In most cases, the generator of
random numbers will follow a specific theoretical distribution. This may be a
weakness of the Monte Carlo Simulations compared to Historical Simulations,
which uses the empirical distribution. When simulating random numbers, we
generally use the normal distribution.
In this paper, we use the standard stock price model to simulate the path of a stock
price from the ith day as defined by:
Ri = (Si+1 - Si) / Si = t + t1/2
where

(1)

Ri is the return of the stock on the ith day

Si is the stock price on the ith day
Si+1 is the stock price on the i+1th day
is the sample mean of the stock price
t is the timestep
is the sample volatility (standard deviation) of the stock price
is a random number generated from a normal distribution

At the end of this step/day (t = 1 day), we have drawn a random number and
determined Si+1 by applying (1) since all other parameters can be determined or
estimated.
Step 3 Repeat Step 2 until reaching the end of the analysis horizon T by walking
along the N time intervals.
At the next step/day (t = 2), we draw another random number and apply (1) to
determine Si+2 from Si+1. We repeat this procedure until we reach T and can
determine Si+T. In our example, Si+22 represents the estimated (terminal) stock price
in one month time of the sample share.
Step 4 Repeat Steps 2 and 3 a large number M of times to generate M different
paths for the stock over T.
So far, we have generated one path for this stock (from i to i+22). Running Monte
Carlo Simulations means that we build a large number M of paths to take account of
a broader universe of possible ways the stock price can take over a period of one
month from its current value (Si) to an estimated terminal price Si+T. Indeed, there is
no unique way for the stock to go from Si to Si+T. Moreover, Si+T is only one possible
terminal price for the stock amongst an infinity. Indeed, for a stock price being
defined on
(a set of positive numbers), there is an infinity of possible paths from
Si to Si+T (see footnote 1).
It is an industry standard to run at least 10,000 simulations even if 1,000 simulations
provide an efficient estimator of the terminal price of most assets. In this paper, we
ran 1,000 simulations for illustration purposes.
Step 5 Rank the M terminal stock prices from the smallest to the largest, read
the simulated value in this series that corresponds to the desired (1-)%
confidence level (95% or 99% generally) and deduce the relevant VaR, which is
the difference between Si and the th lowest terminal stock price.
Let us assume that we want the VaR with a 99% confidence interval. In order to
obtain it, we will need first to rank the M terminal stock prices from the lowest to
the highest. Then we read the 1% lowest percentile in this series. This estimated
terminal price, Si+T means that there is a 1% chance that the current stock price Si
could fall to Si+T or less over the period in consideration and under normal market
1%

1%

conditions. If Si+T is smaller than Si (which is the case most of the time), then Si Si+T will corresponds to a loss. This loss represents the VaR with a 99% confidence
interval.
1%

1%

Applications
Let us compute VaR using Monte Carlo Simulations for one share to illustrate the
algorithm.
We apply the algorithm to compute the monthly VaR for one stock. Historical prices
are charted in Exhibit 1. We will only consider the share price and thus work with
the assumption we have only one share in our portfolio. Therefore the value of the
portfolio corresponds to the value of one share.
Exhibit 1: Historical prices for one stock from 01/22/08 to 01/20/09

From the series of historical prices, we calculated the sample return mean (-0.17%)
and sample return standard deviation (5.51%). The current price (Si) at the end of
the 20th of January 2009 was $18.09. We want to compute the monthly VaR on the
20th of January 2009. This means we will jump in the future by 22 trading days and
look at the estimated prices for the stock on the 19th of February 2009.
Since we decided to use the standard stock price model to draw 1,000 paths until T
(19th of February 2009), we will need to estimate the expected return (also called
drift rate) and the volatility of the share on that day.
We can estimate the drift by