Value-at-Risk: An Introduction

Duke Investment Club

William Eastman, Landon Park, Jackson Pfeiffer,
Peter Bastian, and Lakshya Makhok

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 Historical Method
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over a chosen time interval that will be experienced a given percentage of
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The Historical Method involves simply

taking the times series of daily returns
and ordering it. Suppose one has 100
observations of the returns of a security.
The Historical Method assumes these
observations constitute a probability
distribution for future returns. The 95%
1-­Day Value at Risk (VaR) would
simply be the 6th largest loss.
 Parametric Method

The Parametric Method requires an

assumption to be made about the
probability distribution (normal,
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approximates returns data. Practitioners
have historically used normal
distributions to model percentage asset
price changes with nigh exclusivity.
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follow such distributions neatly in
practice, but this assumption allows for
computationally-­efficient and easily
interpretable results.
 VaR for a Single Security
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‡ VaR is based on a Maximum Likelihood Estimation using historical data and

assuming a normal distribution of percentage returns during disjoint time intervals.

‡ VaR can be calculated using any significance level or loss time period, though 95%
(2ı) and a single trading day are near-­universal industry standards.

‡ Considerable debate exists as to the optimal time window of historical data for VaR
calculation and whether or not different asset classes necessitate different such
windows.

‡ The assumption of normality of percentage returns throughout time is a direct

mathematical implication of log-­normally distributed asset prices, as hypothesized by
leading academics of modern finance, including Myron Scholes and Fischer Black.

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 Portfolio Aggregation of VaR
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variances, weightings, and covariances of individuals securities while using the
weighted average of mean daily market capitalization changes as the daily portfolio
expectation. Because both daily portfolio expectation and variance are calculated
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‡ Calculating VaR on a portfolio level requires the assumption that portfolio percentage
returns are distributed according to a multivariate normal distribution; this is a direct
mathematical implication of the single security case if correlations between asset
classes are constant throughout time.

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‡ Portfolio VaR constitutes a decent back of the envelope estimate for the risk of a
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 History of VaR

‡ VaR concepts emerged in the late 1980s as a result of the stock market crash
of 1987 and was developed as a way to differentiate between extreme events,
such as market crashes, and everyday price movements.

‡ In the early 90s, VaR was used by several quant-­trading groups. Around that
time, JP Morgan CEO Dennis Weatherstone famously called for a report at
the end of the trading day to aggregate firm-­wide risk.
² VaR was the natural choice since many desks already computed it.

‡ In 1997, the SEC ruled that public firms must release quantitative
information about derivatives trading, so major banks chose to include VaR
information in their financial statements. Since then VaR has been the
preferred measure of market risk.

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 Disadvantages of VaR
‡ Price change distributions often display outsized skew and kurtosis (fat tails)
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risk metric limited.

‡ Though VaR is indicative of maximum expected losses under normal

market conditions, it offers no information about losses during a time of
financial duress-­ precisely the scenario under which risk management is most
vital.

‡ Asset correlations are extremely dynamic and unpredictable; estimating

future correlations with historical data is a fundamentally dubious enterprise.

‡ VaR calculation assuming alternative (and theoretically preferable)

probability distributions like the Cauchy distribution is computationally
infeasible for large sets of historical returns of multiple securities.

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 The Future of VaR
‡ &RQGLWLRQDO9D5RU´F9D5µLVDQHYHU-­increasingly used metric by
practitioners. Conditional VaR represents the expected loss of the portfolio
during a VaR break. This is useful because the skew of the distribution of
price changes for a given security is assumed to be greater beyond the
probability threshold chosen for VaR calculation.

‡ Historical VaR break likelihood testing is becoming a more widespread

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fruitful guiding tool-­ *ROGPDQ$%; &0%;WUDGHUVLQ'HF¶

‡ Adjustments to VaR calculation historical data time windows based on

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uncommon.

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 Suggested Reading
Bernstein, Peter L. Against the Gods the Remarkable Story of
Risk. New York: Wiley, 1998.

Lowenstein, Roger. When Genius Failed the Rise and Fall of

Long-­Term Capital Management. New York (N.Y.): Random
House, 2000.

Mandelbrot, Benoit B., and Richard L. Hudson. The

(Mis)behavior of Markets: a Fractal View of Risk, Ruin, and
Reward. New York: Published by Basic, 2006.

Taleb, Nassim. Fooled by Randomness: the Hidden Role of

Chance in Life and in the Markets. New York: Random House,
2005.

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Questions?

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