Risk management attempts to provide financial predictability for a company. Every day firms face financial risks. Interest and exchange rate volatility, default on loans, and changes in credit rating are some examples. These risks can be sorted into two categories – credit risk and market risk. | LECTURE 22 VAR Methods of calculating VAR (Cont.) Correlation method is conceptually simple and easy to apply; it only requires the mean returns and the covariance matrix of asset returns. 2) Historical Simulation: Historical simulation uses actual historic data to predict the returns of risk factors instead of assuming risk factor returns have a normal distribution. To use this simulation to estimate VAR, a risk manager must follow these steps: Gather the market data for each of the assets over the historical period. Value-At-Risk Methods of calculating VAR (Cont.) For example, to value a Treasury bond, collect price and yield information on that type of asset over 250 trading days. ii) Measure the percentage changes in the interest rate from day to day. For example, suppose from the first day to the second day the interest rate declined from to , for a decrease. iii) Value the portfolio for the change that would occur if history repeated itself – if the interest rate changed by the same percentage. Value-At-Risk Methods of calculating VAR (Cont.) For the first sample path in the simulation, decrease the interest rate by , for example from to . Then the bond is valued with this interest rate to calculate a future value. By subtracting the future portfolio value from the current value, an analyst can know the amount that would be lost due to market risk if these conditions occurred again. Repeat this analysis for each trading day in the data period, creating a distribution of possible outcomes for the portfolio. Value-At-Risk Methods of calculating VAR (Cont.) When the distribution is complete, rank all the possible outcomes by gain (or loss) and choose a confidence level for the estimate. The value at that percentile in the distribution represents the VAR for that portfolio. In a simulation of 100 historical trading days, to estimate VAR to the 95% confidence level, select the fifth worst value in the . | LECTURE 22 VAR Methods of calculating VAR (Cont.) Correlation method is conceptually simple and easy to apply; it only requires the mean returns and the covariance matrix of asset returns. 2) Historical Simulation: Historical simulation uses actual historic data to predict the returns of risk factors instead of assuming risk factor returns have a normal distribution. To use this simulation to estimate VAR, a risk manager must follow these steps: Gather the market data for each of the assets over the historical period. Value-At-Risk Methods of calculating VAR (Cont.) For example, to value a Treasury bond, collect price and yield information on that type of asset over 250 trading days. ii) Measure the percentage changes in the interest rate from day to day. For example, suppose from the first day to the second day the interest rate declined from to , for a decrease. iii) Value the portfolio for the change that would occur if history repeated itself – if the
