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Model Building Approach

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654 views7 pages

Model Building Approach

Uploaded by

Jessuel Larn-eps
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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MODEL-BUILDING APPROACH

In this approach, we assume a model


for the joint distribution of changes in market variables and use historical

approach.

The model-building approach is based on ideas pioneered by Harry


Markowitz. We used these ideas for assessing the risk-return trade-offs
in portfolios of stocks

They can also be used to calculate


VaR. Estimates of the current levels of the variances and covariances of
market variables are made using the approaches described in Chapters 5
and 6. If the probability distributions of the daily percentage changes in
market variables are assumed to be normal and the dollar change in the
value of the portfolio is assumed to be linearly dependent on percentage
changes in market variables, VaR can be obtained very quickly.

Daily returns on the investments are normally assumed to be multivariate normal which
can be the models biggest drawback. Hence, model-building approach makes it easy to
calculate Var.

Model Building approach assumes two things:


• The daily change in the value of a portfolio is linearly related to the daily returns from
market variables
• The returns from the market variables are normally distributed

Shortcomings of Model Building Approach


Also this approach is much more complex to use when a portfolio comprises of nonlinear
products such as options. It is also a grim task to relax the assumption that returns are normal
without a significant increase in totaling time.

Model building approach producer quicker results and can be used in conjunction with volatility
and other correlation procedures.
An Introduction to Value at Risk (VAR)
Value at risk (VAR or sometimes VaR) has been called the "new science of risk
management," but you don't need to be a scientist to use VAR.

Here, in Part 1 of this short series on the topic, we look at the idea behind VAR
and the three basic methods of calculating it.

The Idea Behind VAR


The most popular and traditional measure of risk is volatility. The main problem
with volatility, however, is that it does not care about the direction of an
investment's movement: stock can be volatile because it suddenly jumps higher.
Of course, investors aren't distressed by gains.

For investors, the risk is about the odds of losing money, and VAR is based on
that common-sense fact. By assuming investors care about the odds of a really
big loss, VAR answers the question, "What is my worst-case scenario?" or "How
much could I lose in a really bad month?"

Now let's get specific. A VAR statistic has three components: a time period, a
confidence level and a loss amount (or loss percentage). Keep these three parts
in mind as we give some examples of variations of the question that VAR
answers:

 What is the most I can—with a 95% or 99% level of confidence—expect to


lose in dollars over the next month?
 What is the maximum percentage I can—with 95% or 99% confidence—
expect to lose over the next year?

You can see how the "VAR question" has three elements: a relatively high level
of confidence (typically either 95% or 99%), a time period (a day, a month or a
year) and an estimate of investment loss (expressed either in dollar or
percentage terms).

Methods of Calculating VAR


Institutional investors use VAR to evaluate portfolio risk, but in this introduction,
we will use it to evaluate the risk of a single index that trades like a stock:
the Nasdaq 100 Index, which is traded through the Invesco QQQ Trust.
The QQQ is a very popular index of the largest non-financial stocks that trade on
the Nasdaq exchange.1
There are three methods of calculating VAR: the historical method, the variance-
covariance method, and the Monte Carlo simulation.

1. Historical Method
The historical method simply re-organizes actual historical returns, putting them
in order from worst to best. It then assumes that history will repeat itself, from a
risk perspective.

As a historical example, let's look at the Nasdaq 100 ETF, which trades under the
symbol QQQ (sometimes called the "cubes"), and which started trading in March
of 1999.2 If we calculate each daily return, we produce a rich data set of more
than 1,400 points. Let's put them in a histogram that compares the frequency of
return "buckets." For example, at the highest point of the histogram (the highest
bar), there were more than 250 days when the daily return was between 0% and
1%. At the far right, you can barely see a tiny bar at 13%; it represents the one
single day (in Jan 2000) within a period of five-plus years when the daily return
for the QQQ was a stunning 12.4%.

Notice the red bars that compose the "left tail" of the histogram. These are the
lowest 5% of daily returns (since the returns are ordered from left to right, the
worst are always the "left tail"). The red bars run from daily losses of 4% to 8%.
Because these are the worst 5% of all daily returns, we can say with 95%
confidence that the worst daily loss will not exceed 4%. Put another way, we
expect with 95% confidence that our gain will exceed -4%. That is VAR in a
nutshell. Let's re-phrase the statistic into both percentage and dollar terms:

 With 95% confidence, we expect that our worst daily loss will not exceed
4%.
 If we invest $100, we are 95% confident that our worst daily loss will not
exceed $4 ($100 x -4%).

You can see that VAR indeed allows for an outcome that is worse than a return
of -4%. It does not express absolute certainty but instead makes a probabilistic
estimate. If we want to increase our confidence, we need only to "move to the
left" on the same histogram, to where the first two red bars, at -8% and -7%
represent the worst 1% of daily returns:

 With 99% confidence, we expect that the worst daily loss will not exceed
7%.
 Or, if we invest $100, we are 99% confident that our worst daily loss will
not exceed $7.
2. The Variance-Covariance Method
This method assumes that stock returns are normally distributed. In other words,
it requires that we estimate only two factors—an expected (or average) return
and a standard deviation—which allow us to plot a normal distribution curve.
Here we plot the normal curve against the same actual return data:

Image by Julie Bang © Investopedia 2020

The idea behind the variance-covariance is similar to the ideas behind the
historical method—except that we use the familiar curve instead of actual data.
The advantage of the normal curve is that we automatically know where the
worst 5% and 1% lie on the curve. They are a function of our desired confidence
and the standard deviation.

Confidence # of Standard Deviations (σ)

95% (high) - 1.65 x σ

99% (really
- 2.33 x σ
high)

The blue curve above is based on the actual daily standard deviation of the
QQQ, which is 2.64%. The average daily return happened to be fairly close to
zero, so we will assume an average return of zero for illustrative purposes. Here
are the results of plugging the actual standard deviation into the formulas above:

Confidence # of σ Calculation Equals

95% (high) - 1.65 x σ - 1.65 x (2.64%) = -4.36%

99% (really
- 2.33 x σ - 2.33 x (2.64%) = -6.15%
high)

3. Monte Carlo Simulation


The third method involves developing a model for future stock price returns and
running multiple hypothetical trials through the model. A Monte Carlo
simulation refers to any method that randomly generates trials, but by itself does
not tell us anything about the underlying methodology.

For most users, a Monte Carlo simulation amounts to a "black box" generator of
random, probabilistic outcomes. Without going into further details, we ran a
Monte Carlo simulation on the QQQ based on its historical trading pattern. In our
simulation, 100 trials were conducted. If we ran it again, we would get a different
result--although it is highly likely that the differences would be narrow. Here is the
result arranged into a histogram (please note that while the previous graphs have
shown daily returns, this graph displays monthly returns):

To summarize, we ran 100 hypothetical trials of monthly returns for the QQQ.
Among them, two outcomes were between -15% and -20%; and three were
between -20% and 25%. That means the worst five outcomes (that is, the worst
5%) were less than -15%. The Monte Carlo simulation, therefore, leads to the
following VAR-type conclusion: with 95% confidence, we do not expect to lose
more than 15% during any given month.

The Bottom Line


Value at Risk (VAR) calculates the maximum loss expected (or worst case
scenario) on an investment, over a given time period and given a specified
degree of confidence. We looked at three methods commonly used to calculate
VAR. But keep in mind that two of our methods calculated a daily VAR and the
third method calculated monthly VAR. In Part 2 of this series, we show you how
to compare these different time horizons.
What makes them different?
Historical Simulation approach is most frequently used by organisations. As the name
suggests, we consider daily changes in past/historical values to compute the likelihood of
the variations in values of current portfolio between given time frame. The other
advanced version of this model places more emphasis on recent observations. The key
assumption in historical simulation is that the set of possible future outcomes is fully
represented by what occurred in a definite historical time frame/window.
On the other side, model-building approach involves assumptions about the joint
probability distributions of the returns on the market variables. This model is also known
as variance-covariance approach.
This is more apt for portfolios which has short as well as long positions in their bucket.
This consists of commodities, bonds, equities, etc. in the portfolio. Here, the mean and
standard deviation are computed from the distribution of the underlying assets returns
and the correlation between them.
Daily returns on the investments are normally assumed to be multivariate normal which
can be the models biggest drawback. Hence, model-building approach makes it easy to
calculate Var.
Model Building approach assumes two things:
• The daily change in the value of a portfolio is linearly related to the daily returns from
market variables
• The returns from the market variables are normally distributed
Shortcomings of Historical Simulations
Over reliance on past data can fail to serve the purpose as markets change every
moment. The momentum can be gradual or sudden, but does not remain static.
Large number of factors like Technology, regulatory changes, economic conditions,
seasonal patterns, etc. influence market and in such scenarios manager who are using
historical simulation can face unfavorable situation.
Shortcomings of Model Building Approach
Also this approach is much more complex to use when a portfolio comprises of nonlinear
products such as options. It is also a grim task to relax the assumption that returns are
normal without a significant increase in totaling time.
When to use? Model building vs. Historical simulation.
Depending on the situation, appropriate model should be adopted by the organisation.
While both of them have pros and cons, it is important to list down the objectives of risk
model before adopting either of them.
Model building approach producer quicker results and can be used in conjunction with
volatility and other correlation procedures.
The advantage of the historical simulation approach is that the joint probability
distribution of the market variables is determined by historical data. This approach may
not be very complicated however, it is little slow for computation. However, the
methodology used in historical simulation is in line the risk factor and does not involve
any estimation of variances or covariance’s which are statistical parameters.
One should use historical simulation model only when they have data on all risk factors
over a justified historical period if they want the model to depict strong representation
of the outcome in future.
To know more about model building join Imarticus Learning’s Financial Modeling
Certification Courses, which will help you understanding opportunities in the Investment
Banking, Private Equity, Budgeting and Financial Control space.

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