VALUE AT RISK FOR MARKET RISK

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VALUE AT RISK FOR MARKET RISK

• Barry Schachter
• Caxton Corporation

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Agenda

• Practical issues in calculating VaR
• From VaR to stress
• Decisions, decisions putting the numbers to use
• Dealing with data deluge

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Practical Issues in Calculating VaR
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The Love Affair with VaR

• VaRs initial purpose
• Regulators jump in
• Everybodys doing it

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Calculating VaR

• Varieties of models
• With many adaptations
• For non-stationary data
• For non-linear instruments

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The Honeymoon is Over

• Market crises
• The events
• The finger pointing
• VaRs shortcomings
• Looking beyond the data
• Back-filling data
• Interpreting exposure

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Reconciliation

• VaR still has a role to play
• Statistically valid
• Natural portfolio concept (sub-additivity)
• Extensions
• Extreme Value Theory
• Stress Testing

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From VaR to Stress Making Stress Testing a
Useful Complement to VaR
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Stress Tests Emerging Role

• Promoted by Basle Market Risk Amendment
• Varieties of Stress Test
• Scenarios
• Sensitivities

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It Aint All Roses

• Pitfalls in design
• Relevance
• Economically sensible
• Pitfalls in application
• Full re-val
• Disaggregation

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Decisions, Decisions Putting the Numbers to Use
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The Information Role

• Where it all started
• Different needs for different customers
• Drill-down a necessity
• Promote discussion and risk management culture

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Information - Key Questions

• What are contributors to aggregate VaR (natural
  hedges)?
• What drives changes in VaR?
• How significant is tail risk?
• What is the trend in exposure?
• What are concentrations in exposure?

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A Component of Limits

• Enhances non-statistical limits
• But difficult to actively manage
• Calculated with delay
• Interactions difficult to estimate
• And creates perverse incentives
• Gaming behavior
• Trade-off market and credit risk

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Decision Tool

• Strategic hedging
• Benchmarking performance
• Portfolio optimization
• Capital charges

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Dealing with Data Deluge Data Visualization
(in cooperation with FISC/SGI)
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Data vs. Information

• Many dimensions of data
• Many possible relationships
• Limited time to act

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Further reading

• Duffie, Darrell and Jun Pan. 1997. An Overview of
  Value at Risk. Journal of Derivatives 4 (Spring),
  7- 49. Paper http//www.mit.edu/junpan/Abstrac
  t http//www.gloriamundi.org/var/abstracts.htmlo
  verview
• Dowd, Kevin. 1999. The Extreme Value Approach to
  VaR - An Introduction (1) . Financial Engineering
  News (August), 1.Paper http//fenews.com/1999/Is
  sue11/089904.html
• Schachter, Barry. 1998. The Value of Stress
  Testing in Market Risk Management. Derivatives
  Risk Management Service (March). Paper
  http//www.gloriamundi.org/var/pub/drms.pdf
• Lawrence, Stephen. 2000. Value at Risk
  Incorporating Dynamic Portfolio Management.
  Working paper, Boston College (June). Paper
  http//www2.bc.edu/lawrenst/varpaper.pdf
  Abstract http//www.gloriamundi.org/var/abstract
  s00.htmlsl
• http//www.GloriaMundi.org/ for more VaR
  literature links