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Valuse At Risk Essay

2602 words - 11 pages

1.) INTRODUCTION.Managing financial risk is an important aspect of any financial institution. Financial disasters have proved that millions of dollars can be lost through poor financial management and supervision of financial risks. A financial manager is not only interested in the returns from the investments in a market but also the possible extreme and abnormal returns that seem possible. Without a careful analysis of the potential danger, the investment could cause catastrophical consequence when a shock occurs. With the experience of recent failure of large financial institutions such as the Barings Bank, sufficient risks control measures are clearly essential and the regulators have ...view middle of the document...

2) DETERMINING THE VALUE AT RISK.There are many methods to calculate VaR, which fit different market conditions, data set and precision requirements. There are some of the more popular and effective ones. Generally, we can classify them into three types2.1) Variance Co-variance Approach:This method is based on the assumption that the short term changes in the market parameters and in the value of the portfolio are normal. In this method the market parameters are nondependent and are restricted to the first degree of dependence -correlation. Yiu. K.F.C (2004) says that this is was pioneered by Markowitz 1952] and is basically a single-period model which makes an one-off decision at the beginning of the period and holds on until the end of the period.(S.Benninga and Z.Wiener, 1998) say that this method is the fastest but however it relies heavily on several assumptions about the distribution of Market beta and linear approximation of the portfolio. There is bound to be high convexity in the case of options and bonds.(Gencay.R and Selcuk.F, 2004) argue that "Although sample variance as an estimator of the standard deviation in variance-covariance approach is simple, it has drawbacks at high quantiles of a fat-tailed empirical distribution. The quantile estimates of the variance-covariance method for the right tail (left tail) are biased downwards (upwards) for high quantiles of a fat-tailed empirical distribution. Therefore, the risk is underestimated with this approach. Another drawback of this method is that it is not appropriate for asymmetric distributions.Despite these drawbacks, this approach is commonly used for calculating the VaR from holding a certain portfolio, since the VaR is additive when it is based on sample variance under the normality assumption".2.2) Historical simulation:This method consists of going back in time and applying current weights to a time series of historical asset returns. These returns reconstruct the history of a hypothetical portfolio using the current position of the portfolio. In this method, the past variations in the distribution of changes in prices and rates. These past data are applied to the current set of rates, and then uses those to revalue the portfolio. This set of portfolio revaluations corresponding to the set of possible realizations of rates and the 99th percentile loss is narrowed down as the value at risk.(S.Benninga and Z.Wiener, 1998) "The historical simulation is important when the amount of data is minimum and when the information about the profit and loss distribution is limited. But its main advantage is that it catches all recent market crashes".(Gencay.R and Selcuk.F, 2004) Argues that" The disadvantage of this method is that the high quantile estimates are not reliable since they are calculated from only a few observations. Furthermore, it is not possible to obtain any quantile estimates above the highest observed quantile.2.3) Monte Carlo simulation:This is a simulation technique in...

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