Lecture 5

Value at Risk and Expected Shortfall

Chapter 12
Risk Management and Financial Institutions 4e
by John C. Hull

1
The question being asked in
Value at Risk

“What loss level is such that we are X%

confident it will not be exceeded in N business
days?”

Risk Management and Financial Institutions 4e, Chapter 12, Copyright © John C. Hull 2015 2
 VaR and regulatory capital
 Regulators base the capital they require
banks to keep on VaR

 The market-risk capital has traditionally been

calculated from a 10-day VaR estimated where
the confidence level is 99%

 Credit risk and operational risk capital are

based on a one-year 99.9% VaR

Risk Management and Financial Institutions 4e, Chapter 12, Copyright © John C. Hull 2015
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Advantages of VaR
 It captures an important aspect of risk
in a single number

 It is easy to understand

 It asks the simple question: “How bad can

things get?”

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Example 12.1
 The gain from a portfolio during six month is
normally distributed with mean $2 million and
standard deviation $10 million

 The 1% point of the distribution of gains is

2−2.33×10 or − $21.3 million

 The VaR for the portfolio with a six month time

horizon and a 99% confidence level is $21.3
million.

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Example 12.2
 All outcomes between a loss of $50 million
and a gain of $50 million are equally likely
for a one-year project

 The VaR for a one-year time horizon and a

99% confidence level is $49 million

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Examples 12.3 and 12.4
 A one-year project has a 98% chance of
leading to a gain of $2 million, a 1.5%
chance of a loss of $4 million, and a 0.5%
chance of a loss of $10 million

 The value at risk (VaR) with a 99%

confidence level is $4 million

 What if the confidence level is 99.9%?

 What if it is 99.5%?

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Cumulative Loss Distribution for
Examples 12.3 and 12.4 (Figure 12.3)

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 VaR versus Expected Shortfall
 VaR is the loss level that will not be exceeded
with a specified probability
 Expected shortfall (ES) is the expected loss given
that the loss is greater than the VaR level (also
called C-VaR and Tail Loss)
 Regulators have indicated that they plan to move
from using VaR to using ES for determining
market risk capital
 Two portfolios with the same VaR can have very
different expected shortfalls

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Distributions with the same VaR but different
Expected Shortfalls

VaR

VaR
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Coherent Risk Measures
 Define a coherent risk measure as the amount
of cash that has to be added to a portfolio to
make its risk acceptable
 Properties of coherent risk measure
 If one portfolio always produces a worse outcome than
another, its risk measure should be greater
 If we add an amount of cash K to a portfolio its risk
measure should go down by K
 Changing the size of a portfolio by  should result in
the risk measure being multiplied by 
 The risk measures for two portfolios after they have
been merged should be no greater than the sum of
their risk measures before they were merged

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VaR versus expected shortfall
 VaR satisfies the first three conditions but not
the fourth one

 ES satisfies all four conditions.

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Example 12.5 and 12.7
 Each of two independent projects has a
probability 0.98 of a loss of $1 million and 0.02
probability of a loss of $10 million

 What is the 97.5% VaR for each project?

 What is the 97.5% expected shortfall for each

project?

 What is the 97.5% VaR for the portfolio?

 What is the 97.5% expected shortfall for the

portfolio?

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Examples 12.6 and 12.8
 A bank has two $10 million one-year loans. Possible
outcomes are as follows
Outcome Probability

Neither Loan Defaults 97.5%

Loan 1 defaults, loan 2 does not default 1.25%

Loan 2 defaults, loan 1 does not default 1.25%

Both loans default 0.00%

 If a default occurs, losses between 0% and 100% are

equally likely. If a loan does not default, a profit of 0.2
million is made.
 What is the 99% VaR and expected shortfall of each project
 What is the 99% VaR and expected shortfall for the portfolio

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Spectral risk measures
1. A spectral risk measure assigns weights to
quantiles of the loss distribution
2. VaR assigns all weight to Xth percentile of the
loss distribution
3. Expected shortfall assigns equal weight to all
percentiles greater than the Xth percentile
4. For a coherent risk measure weights must be
a non-decreasing function of the percentiles

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Normal distribution assumption
 When losses (gains) are normally distributed
with mean  and standard deviation 

VaR     N  1 ( X )
Y 2 2
e
ES    
2 (1  X )

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Changing the time horizon
 If losses in successive days are independent,
normally distributed, and have a mean of zero

T - day VaR  1 - day VaR  T

T - day ES  1 - day ES  T

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Extension
 If there is autocorrelation  between the losses
(gains) on successive days, we replace T by

T  2 (T  1)   2 (T  2 )  2  2 (T  3)  3    2  T 1
in these equations

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Ratio of T-day VaR to 1-day VaR
(Table 12.1)

T=1 T=2 T=5 T=10 T=50 T=250

=0 1.0 1.41 2.24 3.16 7.07 15.81

=0.05 1.0 1.45 2.33 3.31 7.43 16.62

=0.1 1.0 1.48 2.42 3.46 7.80 17.47

=0.2 1.0 1.55 2.62 3.79 8.62 19.35

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Choice of VaR parameters
 Time horizon should depend on how quickly
portfolio can be unwound. Regulators are
planning to move toward a system where ES is
used and the time horizon depends on liquidity.
(See Fundamental Review of the Trading Book)

 Confidence level depends on objectives.

Regulators use 99% for market risk and 99.9%
for credit/operational risk.
 A bank wanting to maintain a AA credit rating
might use confidence levels as high as 99.97%
for internal calculations.

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Aggregating VaRs
An approximate approach that seems to works
well is
VaR total    VaR
i j
i VaR j  ij

where VaRi is the VaR for the ith segment,

VaRtotal is the total VaR, and ij is the coefficient
of correlation between losses from the ith and
jth segments

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VaR measures for a portfolio where an
amount xi is invested in the i-th component
of the portfolio

 Marginal VaR: VaR

xi

 Incremental VaR: Incremental effect of the ith

component on VaR

 Component VaR:
VaR
xi
xi

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Properties of component VaR
 The component VaR is approximately the same
as the incremental VaR

 The total VaR is the sum of the component

VaR’s (Euler’s theorem)

 The component VaR therefore provides a

sensible way of allocating VaR to different
activities

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