VaR in nancial risk
management
GA RCH MODELS IN P YTH ON
Chelsea Yang
Data Science Instructor
Risk management mindset
Rule No.1: Never lose money
Rule No.2 Never forget Rule No.1
-- Warren Buffett
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What is VaR
VaR stands for Value at Risk
Three ingredients:
1. portfolio
2. time horizon
3. probability
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VaR examples
_1-day 5% VaR of $1 million _
5% probability the portfolio will fall in value by 1 million dollars or more over a 1-day period
10-day 1% VaR of $9 million
1% probability the portfolio will fall in value by 9 million dollars or more over a 10-day period
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VaR in risk management
Set risk limits
VaR exceedance: portfolio loss exceeds the VaR
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Dynamic VaR with GARCH
More realistic VaR estimation with GARCH
VaR = mean + (GARCH vol) * quantile
VaR = mean_forecast.values + np.sqrt(variance_forecast).values * quantile
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Dynamic VaR calculation
Step 1: Use GARCH model to make variance forecast
# Specify and fit a GARCH model
basic_gm = arch_model(bitcoin_data['Return'], p = 1, q = 1,
mean = 'constant', vol = 'GARCH', dist = 't')
gm_result = basic_gm.fit()
# Make variance forecast
gm_forecast = gm_result.forecast(start = '2019-01-01')
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Dynamic VaR calculation (cont.)
Step 2: Use GARCH model to obtain forward-looking mean and volatility
mean_forecast = gm_forecast.mean['2019-01-01':]
variance_forecast = gm_forecast.variance['2019-01-01':]
Step 3: Obtain the quantile according to a con dence level
1. Parametric VaR
2. Empirical VaR
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Parametric VaR
Estimate quantiles based on GARCH assumed distribution of the standardized residuals
# Assume a Student's t-distribution
# ppf(): Percent point function
q_parametric = garch_model.distribution.ppf(0.05, nu)
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Empirical VaR
Estimate quantiles based on the observed distribution of the GARCH standardized residuals
q_empirical = std_resid.quantile(0.05)
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Let's practice!
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Dynamic covariance
in portfolio
optimization
GA RCH MODELS IN P YTH ON
Chelsea Yang
Data Science Instructor
What is covariance
Describe the relationship between movement of two variables
Positive covariance: move together
Negative covariance; move in the opposite directions
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Dynamic covariance with GARCH
If two asset returns have correlation ρ and time-varying volatility of σ1 and σ2 :
Covariance = ρ ⋅ σ1 ⋅ σ2
covariance = correlation * garch_vol1 * garch_vol2
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Calculate GARCH covariance in Python
Step 1: Fit GARCH models and obtain volatility for each return series
# gm_eur, gm_cad are fitted GARCH models
vol_eur = gm_eur.conditional_volatility
vol_cad = gm_cad.conditional_volatility
Step 2: Compute standardized residuals from the tted GARCH models
resid_eur = gm_eur.resid/vol_eur
resid_cad = gm_cad.resid/vol_cad
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Calculate GARCH covariance in Python (cont.)
Step 3: Compute ρ as simple correlation of standardized residuals
corr = np.corrcoef(resid_eur, resid_cad)[0,1]
Step 4: Compute GARCH covariance by multiplying the correlation and volatility.
covariance = corr * vol_eur * vol_cad
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Modern portfolio theory (MPT)
Pioneered by Harry Markowitz in his paper "Portfolio Selection"(1952)
Take advantage of the diversi cation effect
The optimal portfolio can yield the maximum return with the minimum risk
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MPT intuition
Variance of a simple two-asset portfolio:
_W1∗ Variance1 + W2∗ Variance2 + 2∗W1∗W2∗Covariance _
Diversi cation effect:
Risk can be reduced in a portfolio by pairing assets that have a negative covariance
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Let's practice!
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Dynamic Beta in
portfolio
management
GA RCH MODELS IN P YTH ON
Chelsea Yang
Data Science Instructor
What is Beta
Stock Beta:
a measure of stock volatility in relation to the general market
Systematic risk:
the portion of the risk that cannot be diversi ed away
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Beta in portfolio management
_Gauge investment risk _
Market Beta = 1: used as benchmark
Beta > 1: the stock bears more risks than the general market
Beta < 1: the stock bears less risks than the general market
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Beta in CAPM
Estimate risk premium of a stock
CAPM: Capital Asset Pricing Model
E(Rs ) = Rf + β (E(Rm ) − Rf )
E(Rs ): stock required rate of return
Rf : risk-free rate (e.g. Treasuries)
E(Rm ): market expected return (e.g. S&P 500)
E(Rm ) − Rf : Market premium
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Dynamic Beta with GARCH
Beta = ρ * σ _stock / σ __market
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Calculate dynamic Beta in Python
1). Compute correlation between S&P500 and stock
resid_stock = stock_gm.resid / stock_gm.conditional_volatility
resid_sp500 = sp500_gm.resid / sp500_gm.conditional_volatility
correlation = numpy.corrcoef(resid_stock, resid_sp500)[0, 1]
2). Compute dynamic Beta for the stock
stock_beta = correlation * (stock_gm.conditional_volatility /
sp500_gm.conditional_volatility)
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Let's practice!
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Congratulations!
GA RCH MODELS IN P YTH ON
Chelsea Yang
Data Science Instructor
You did it
Fit GARCH models
Make volatility forecast
Evaluate model performance
GARCH in action: VaR, covariance, Beta
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Going forward
Time series analysis
ARIMA (AutoRegressive Integrated Moving Average) models
CAPM (Capital Asset Pricing Model)
Portfolio optimization
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Have fun and keep
improving!
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