Options, Futures, and Other Derivatives

Tenth Edition

Chapter 22
Value at Risk and
Expected Shortfall

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The Question Being Asked in VaR
“What loss level is such that we are X% confident it will not be
exceeded in N business days?”

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VaR vs. Expected Shortfall
• VaR is the loss level that will not be exceeded with a specified
probability
• Expected Shortfall (or C-VaR) is the expected loss given that the loss
is greater than the VaR level
• Although expected shortfall is theoretically more appealing, it is VaR
that is used by regulators in setting bank capital requirements

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VaR and ES
• VaR 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?”
• ES answers the question: “If things do get bad, just how bad will they
be”

𝑁 𝑑𝑎𝑦 𝑉𝑎𝑅=1 𝑑𝑎𝑦 𝑉𝑎𝑅 ∗ √ 𝑁

𝑁 𝑑𝑎𝑦 𝐸𝑆 =1 𝑑𝑎𝑦 𝐸𝑆 ∗ √ 𝑁

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Historical Simulation to Calculate the
One-Day VaR or ES (1 of 2)
• Create a database of the daily movements in all market variables.
• The first simulation trial assumes that the percentage changes in all
market variables are as on the first day
• The second simulation trial assumes that the percentage changes in
all market variables are as on the second day
• and so on

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Historical Simulation (2 of 2)
• Suppose we use 501 days of historical data (Day 0 to Day 500)

• Let vi be the value of a variable on day i

• There are 500 simulation trials

• The ith trial assumes that the value of the market variable tomorrow is

vi
v500
vi 1

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Example: Calculation of 1-day, 99% VaR or ES
for a Portfolio on Sept 25, 2008

Index Value ($000s)

DJIA 4,000

FTSE 100 3,000

CAC 40 1,000

Nikkei 225 2,000

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Data After Adjusting for Exchange Rates

Day Date DJIA FTSE 100 CAC 40 Nikkei 225

0 Aug 7, 2006 11,219.38 11,131.84 6,373.89 131.77
1 Aug 8, 2006 11,173.59 11,096.28 6,378.16 134.38
2 Aug 9, 2006 11,076.18 11,185.35 6,474.04 135.94
3 Aug 10, 2006 11,124.37 11,016.71 6,357.49 135.44
Blank Blank Blank Blank Blank Blank
499 Sep 24, 2008 10,825.17 9,438.58 6,033.93 114.26
500 Sep 25, 2008 11,022.06 9,599.90 6,200.40 112.82

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Scenarios Generated
11,173.59
11,022.06   10,977.08
11,219.38

Portfolio Loss
Scenario DJIA FTSE 100 CAC 40 Nikkei 225 Value ($000s) ($000s)
1 10,977.08 9,569.23 6,204.55 115.05 10,014.334 −14.334

2 10,925.97 9,676.96 6,293.60 114.13 10,027.481 −27.481

3 11,070.01 9,455.16 6,088.77 112.40 9,946.736 53.264

Blank Blank Blank Blank Blank Blank Blank

499 10,831.43 9,383.49 6,051.94 113.85 9,857.465 142.535

500 11,222.53 9,763.97 6,371.45 111.40 10,126.439 −126.439

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Ranked Losses

Scenario Number Loss ($000s)

494 477.841
339 345.435
99% one-day VaR
349 282.204
329 277.041
487 253.385
227 217.974
131 205.256

99% one day ES is average of

the five worst losses or $327,181

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The N-day VaR or ES
• The N-day VaR (ES) for market risk is usually assumed to be N
times the one-day VaR (ES)
• In our example the 10-day VaR would be calculated as
10  253,385  801,274
• This assumption is only perfectly theoretically correct if daily
changes are normally distributed with zero mean and independent

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Stressed VaR and Stressed ES
• Stressed VaR and stressed ES calculations are based on historical
data for a stressed period in the past (e.g., the year 2008) rather
than on data from the most recent past (as in our example)

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The Model-Building Approach
• The main alternative to historical simulation is to make assumptions
about the probability distributions of the return on the market
variables and calculate the probability distribution of the change in
the value of the portfolio analytically
• This is known as the model building approach or the variance-
covariance approach

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Daily Volatilities (1 of 2)
• In option pricing we measure volatility “per year”
• In VaR and ES calculations we measure volatility “per day”

 y ear
 day 
252

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Daily Volatility (2 of 2)
• Theoretically, sday is the standard deviation of the continuously
compounded return in one day
• In practice we assume that it is the standard deviation of the
percentage change in one day

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Single Asset Case: Microsoft Example
• We have a position worth $10 million in Microsoft shares
• The volatility of Microsoft is 2% per day (about 32% per year)
• We use N =10 and X = 99

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Microsoft Example
• The standard deviation of the change in the portfolio in 1 day is
$200,000
• The 1-day 99% VaR is
200,000  2 .326  $ 465,300
• The 10-day 99% VaR is

10  465,300  1,471,300

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Single Asset Case: AT&T Example
• Consider a position of $5 million in AT&T
• The daily volatility of AT&T is 1% (Approx. 16% per year)
• The 10-day 99% VaR is

10  2.326  50,000  367,800

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Two Asset Case: Portfolio
• Now consider a portfolio consisting of both Microsoft and AT&T
• Assume that the returns of AT&T and Microsoft are bivariate normal
• Suppose that the correlation between the returns is 0.3

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S.D. of Portfolio
• A standard result in statistics states that

 X Y   2X   Y2  2 X  Y

• In this case sX = 200,000 and sY = 50,000 and r = 0.3. The standard

deviation of the change in the portfolio value in one day is therefore
220,200

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VaR for Portfolio
• The 10-day 99% VaR for the portfolio is

220,200  10  2.326  $1,620,100

• The benefits of diversification are

(1,471,300 + 367,800) – 1,620,100 = $219,00

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ES for the Model Building Approach
• When the loss over the time horizon has a normal distribution with
mean m and standard deviation s, the ES is
2
e Y 2
ES    
2 (1  X )

where X is the confidence level and Y is the Xth percentile of a

standard normal distribution
• For the Microsoft + AT&T portfolio ES is $1,856,100

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