VaR as A Percentile

By Richard Diamond

Abstract:
The primary purpose of this note is to expand the concept of Value at Risk (VaR) from a formula based on the
critical value from Normal distribution, as commonly introduced, to its true definition of being a property of the
joint probability distribution of risk factors. To gain clear and exible view on VaR use, it is necessary to
separate the statistic from the purposes of risk measurement and stress-testing it is used for. Practical
calculation of VaR uses asset price observations (aka scenarios){ operation with empirically-de_ned probability
distribution creates exibility. For all critique of VaR, there closely exists Conditional Value at Risk (CVaR) that
possesses all desired properties of a coherent and homogenous risk measure.
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VaR as A Percentile
c
Richard Diamond

Abstract
The primary purpose of this note is to expand the concept of Value at Risk (VaR)
from a formula based on the critical value from Normal distribution, as commonly
introduced, to its true definition of being a property of the joint probabilty distribution of risk factors. To gain clear and flexible view on VaR use, it is necessary to
separate the statistic from the purposes of risk measurement and stress-testing it is
used for. Practical calculation of VaR uses assset price observations (aka scenarios)
operation with empirically-defined probability distribution creates flexibility. For all
critique of VaR, there closely exists Conditional Value at Risk (CVaR) that possesses
all desired properties of a coherent and homogenous risk measure.
The note is ultimately useful for initiation to the expert language of risk estimation and management.
The note was revised on July 30, 2013. The author can be contacted at richard.diamond@me.com.

Unfolding VaR Figure

Common presentation of VaR is a figure calculated as

Factor t S

(1)

where Factor is a crtical value selected form the Normal distribution given the
level of confidence. Reading formula 1 literally, VaR is a Z-score multiplied by

dispersion t and converted into money equivalent by S term. The formula

flattens out the fact that VaR comes from a joint distribution of risk factors, which
becomes more evident from the practices of VaR calculation:
(a) Ready VaR formulae as above require knowledge of the moments , of a
joint distribution of all assets in the portfolio. The estimation is parametric.
If marginal distributions can assumed to be Normal, VaR will be a coherent
1

risk measure (see Appendix for a proof). In practice, variance estimation is

bound to a time window and drift estimation is problematic because of its
nature as an unconditional expectation. In order to avoid these limitations, a
VaR calculation has to operate with empirical distributions of asset returns.
(b) Bootstrapping method of VaR calculation implies equal weight of each observation of past asset price, and therefore, highlights the definition of VaR as
a percentile. Often, average asset values are selected from 1% of empirically
observed worst moves, for instance, over past 800 days). This is equivalent to
the kenrnel estimation of an empirical distribution plus a window constraint.
The constraint is a relative ranking view in the sense of [4] on a statistic that
adds mean and standard deviation. If we assume a constant mean, VaR can
be seen as a view on volatility, and therefore, it makes sense to compare the
two figures. VaR breaches plotted together with volatility is a common tool.
The concept of VaR as a percentile and threshold value follows from its definition:
Pr(X x) = 1 c =
Pr(X VaR (X)) = .
The probability is analysed at the left tail, with the familiar notation of confidence
level c and significance level . X plays a dual role in this defintion, simple and
general: the absolute amount of loss given portfolio allocation w and general which
is a multi-dimensional random variable representing return distributions.
In order to specify any formula for VaR (X) we need to assume a parametric
probability distribution, and use its inverse (cdf ) in order to bring the value of
VaR (X) outside of probability operator. In the case of the Normal distribution,
we standartise VaR (X):


VaR (X)
Pr

VaR (X) = + 1 (1 )
| {z }

= . . . t Factor
We recovered Equation 1 formula with a time-scaled standard deviation.
2

Conditional VaR (CVaR)

CVaR is an expectation that a portfolio value will be below the VaR threshold.
It also called a tail conditional expectation (TSE) and appears to be more wholesome estimator of loss than VaR. Intuition suggests that being an average, CVaR
should have special properties which are (a) smoothness and (b) being estimable
using Monte-Carlo.
CVaR (X) = E[X|X VaR (X)]

(2)

Consistently with its nature of being an expectation, CVaR can be generally understood as an average loss given realisation of tail risk. This is different from VaR
being a threshold value that only defines where the tail starts.
VaR is not a coherent measure of risk because is not guaranteed to have subadditivity (depending of a view, the property can also be referred to as superadditivity). However, CVaR follows sub-additivity and so it is a coherent measure! Mathematical presentation of the properties of a coherent risk measure in
Appendix relies on multivariate Normal distribution of assets, for which matrix
calculations are well-defined in analytic form.
For example, empirical distributions of equity returns, tend to be higher-peaked
and fatter-tailed as compared to the Normal.
CVaR is also known as Expected Shortfall (ES). The definition of an average loss below a threshold is clear in the formula: integration means adding up
percentiles and dividing by to get an average percentile per bucket (a tail).
1
CVaR (X) = ES =

VaR (X)d
0

With Radon-Nikodym derivative of dQ

1 , expected shortfall comes natural in
dP
the risk-neutral world
CVaR (X) = ES = EQ [X]
Where Q means that we only consider a tail of the distribution of the random
variable X that corresponds to the significance level .

2.1

Index of Satisfaction

We can use moments of a joint distribution of either asset returns or risk factors
to construct an index of satisfaction, as a function of allocation w. Three wellknown cases of satisfaction indicies are:
1. When using only the first moment, index of satisfaction is just the expected
return E[Xw ] which is maximised.
2. We might take into account uncertainty of getting positive expected return,
which is measured by standard deviation. Adjusting the first moment by the
second moment leads to a scale-invariant index of satifaction, Sharpe Ratio
E[Xw ]
SRw =
.
Sd[Xw ]
3. We can define any trade-off between a portfolio expected return E[Xw ] and its
standard deviation Sd[Xw ]. In Modern Portfolio Theory, variance Var[Xw ] =
w0 w is minimised subject to the returns level constraint (by quadratic optimisation method). This is an inverse way to define an index of satisfaction.
The link between expected return and standard deviation can be made using
a utility function.
Mean-VaR or CVaR trade-offs can also be defined and calculated analytically
subject to the Normal distribution of asset returns assumption.

The mean-variance tradeoff is the operative assumption and condition of Capital

Asset Pricing Model derivation. CAPM is an example of mean and standard
deviation combined into a single statistic of an index of satisaction. The statistic
can be specialied or improved by including the higher moments leading to multimoment CAPM.
In order to link the index of satisfaction statistic to the joint distribution of
asset returns, conditioning on allocation w is required. In this context, CVaR is
ES
a partial derivative of an index of satisfaction wrt to allocation w,
. The
w
differentiation plays a role of conditioning on choosen allocation.

If expected shortfall ES is an index of satisfaction, then taking a partial derivative wrt w gives
Z
ES
1
=
VaR (Xw )d
w
w 0
Z
1
Xw
=
VaR (
)d
0
w
= (returning to definiton of ES via an expectation)
= E[R|w0 R VaR (Xw )]
= CVaR (Xw ).
CVaR (X) remains an expection of a mutli-variate return distribution R but now
conditioned on the weighted allocation. Mathematically, this is possible due to
Euler decomposition for a homogenous function. The languages of derivaties and
Xw
portfolio management are linked by
= R and Xw = w0 R allocation accordw
ing to weights w converts expected returns R into the money equivalent gain/loss
Xw . Ultimately, VaR depends on expected returns R: since w0 is a vector of
constant weights, positive homogeneity property gives VaR (w0 R) = w0 VaR (R),
and therefore, E[R|R VaR (R)] which is the same as Equation 2 with R X.
Expected shortfall ES is also a spectral index of satisfaction - that is, it can be
decomposed into a weighted average of outcomes under the empirical distribution.
On the other hand, an index of satisfaction can be defined using a utility function
that models an investors objective: insert allocation w into a utility function u(w)
to obtain some level of satisfaction about that allocation.

Stress-testing with VaR (SVaR)

Utility functions and parametric statistics are nice in terms of analytical solutions but in practice we are bound to work with empirical distributions and
numerically. This is scenario-based approach. SVaR, in turn, is another name for
stress-testing which is the aim of scenario approach.

In quant finance world of SDEs, a risk factor is represented by Brownian Motion

dX. Risk factors are normally considered to be uncorrelated. Each reasonable
discrete value for a risk factor represents a scenario. We are usually interested in
combinations of scenarios for several risk factors, and when they breach thresholds.
Stress-testing with a joint distribution would be done using separation of joint
and marginals and sampling by copula method. But a challenge ensues - how do we
conduct stress-testing without (a) need to transform empirical distributions into
parameterizied Normal and (b) generating new quasi-random values for MonteCarlo generation for each scenario?
Such efficient stress-testing can achieved by artificially increasing probabilities
for some scenarios, as compared to their historical occurrence. Here, subjective
assignment of probabilities is involved but we dont assign say p=0.7 that asset will
be 120 and 1-p=0.3 that a portfolio will be 80 - that would be hit and miss. Instead,
we use a function of the number of asset steps and assign equal or exponential
probability for each asset step (e.g., 0.1), so things are done on average. Regime
switching can be done as a binary stress testing - switch on and off risk factors
depending on asset prices as shown in Figure 2 of [2].
A common stress-testing w.r.t. correlation and volatility is done by imposing
constraints on asset returns [5]. For credit products, it is known as Sensitivity
Analysis. As a fast heuristic, we like to check if VaR breaches co-inside with a
particularly high volatility of the market, index CDS, or other relevant benchmark.
Statistical methods of VaR calculation and discussion about its use in stresstesting might obstruct its nature of being a single threshold value.
The advantage of VaR and CVaR is positive homogeneity that allows decomposition to contributions from individual components.

Outline

Besides its useful mathematical properties, CVaR can be decomposed into liquidity component and market risk component [1] with similar possibilities to credit
(default) risk. VaR methodology can be extended to include transaction costs.
Having considered definitions and practical statistical methods of work with VaR,
it is possible to summarise the following scheme of its definition and calculation:
6

1. A percentile of a joint distribution of asset retuns, with calculation methods

using iid invariants from
(a) Copula sampling that relies on application of inverse empirical cdf of
marginal distributions and specification of corelation structure.
(b) Dimension reduction using either Linear Factor Models or spectral decomposition (i.e., PCA).
2. Conditional VaR with better properties of being an average loss under a
threshold
(a) A conditional expectation that a portfolio value will be below VaR
threshold that can be estimated as an average using Monte-Carlo simulations.
(b) A partial derivative of an index of satisfaction that can be defined as either a single statistic (such as mean-variance tradeoff in MPT) or utility
function.
A joint distribution of returns of thousands of assets, recorded empirically over
a long timeframe, is computationally inefficient to work with. The main problem
comes from the need to account for co-movement. Two major and differerent
statistical toolboxes are applied: (a) separation of joint and marginal distributions
using copula approach and (b) dimension reduction.
4.1

Dimension Reduction

The practice of VaR calculation requires dimension reduction of those thousands of assets represented by X to linear risk factors X = a+BF +U represented
by F - the approach is called Linear Factor Models (LFM). In fact, risk factors are
reduced to their residulals U which should have the property of being identically
and independently distributed (iid ). This represents a quest for invariance: we
would like to rely on iid invariants in estimation because we can simulate any
random values or shocks and insert instead of an iid variable.
For example, diffussion term dX that appears in all quant finance SDEs is such
an iid variable.
7

The myth of isolating systematic factors falls when confronted with empirical
fact that no LFM model can produce uncorrelated residuals [3]. Therefore, further analysis using a spectral decomposition of residuals covariance matrix U into
principal components (PCA) is often appropriate.
Working with reduced models and risk factors facilitates the common economising practice of risk estimation and stress-testing - that is, to avoid re-pricing. The
other benefit of working with risk factors/principal components is that re-pricing
is avoided and, in some approaches, scenario and stess-testing are possible without
re-running of Monte-Carlo. Marking to market a book of derivatives (that includes
OTC products such as exotic options, swaps and credit products) presents financial risk together with logistical, computational, and model validation challenges.
But the model risk, also known as Estimation Risk, has to be managed.
For example, optimising across linear factors F is more sensitive to setup and
constraints than optimising across marginal asset return distributions X.

References
[1] Meucci, Attilio. 2012. Fully Integrated Liquidity and Market Risk Model. Financial Analyst Journal, 25(4), pp. 61-65
[2] Meucci, Attilio. 2010a. Personalized Risk Management: Historical Scenarios
with Fully Flexible Probabilities,. GARP Risk Professional. December 2010,
pp. 47-51.
[3] Meucci, Attilio. 2010b. Review of Linear Factor Models.
[4] Meucci, Attilio. 2008. Fully Flexible Views: Theory and Practice. Risk, 21(10),
pp. 97-102.
[5] Qian, Edward & Gorman, Stephen. 2001. Conditional Distribution in Portfolio Theory. Financial Analysts Journal, 57(2).

Coherent Risk Measure

From among the properties of a coherent risk measure defined by Artzner et al.
(1997), sub-additivity and monotonicity pose the main challenge for empirical asset
price distributions that do not resemble the Normal. For Normally distributed
assets is possible to explore sub-additivity and monotonicity in a tractable way
because we can specify the joint Normal distribution analytically, with reliance on
a linear correlation parameter.
For a bi-variate Normal distribution of two assets X1 N (1 , 12 ) and X2
N (2 , 22 ). Adding up two Normal random variables leads to another Normal
distribution as follows:
X1 + X2 N (1 + 2 , )
where = 12 + 21 2 12 + 22 . Using the formula for VaR (X), we obtain the
proof for sub-additivity
q
VaR (X1 + X2 ) = 1 + 2 + 12 + 21 2 12 + 22 1 (1 )
1 + 2 + (1 + 2 ) 1 (1 )
VaR (X1 ) + VaR (X2 )
Monotonicity in the case of Normally distributed variables follows from the definition of VaR as a percentile: for X1 X2 , any percentile VaR (X1 ) VaR (X2 ).
A combination of these properties, co-monotonic addivity, would represent an
ideal case because co-monotonic additive risk measure (index of satisfaction) would
not be affected by non-linearity of derivatives. For example, it would reflect the
fact that Greeks of derivatives will change as the underlying price change. Adding
derivatives or any payoffs that depends on held underlying would not create a
difersification effect. Small changes in allocation w can make VaR to appear significantly lower - this does not happen with a coherent measure of risk.
While VaR is sub-additive, CVaR (Expected Shortfall) is co-monotonic additive
and super-additive.
CVaR (X1 + X2 ) CVaR (X1 ) + CVaR (X2 )
The higher average loss on holding two assets implies a correlation risk.
9

VaR and CVaR for Empirical Distributions

The mean of an empirical distribution can be computed as the first moment
Z
E[X] =
xf (x)dx
=

R
T
X
t=1
T
X

Z
x(x xt )dx

pt
R

pt x t

t=1

To pool dispersed asset prices (scenarios) into a pdf Dirac delta function is used.
The function spikes to 1 at each observed asset price xt and is 0 everywhere else.
This is a technique of giving a generalised analytical construction to empirical distributions. pt is a unit of flexible and unconditional probability. It can set using
either a distribution or pt T1 . The latter case is kernel type of estimation with
assignment of equal probability density to each observation.
Since VaR is a percentile, VaR (X) = max xt is an asset price level that correX
sponds to the sum of probabilities
pt xt VaR(X). For an empirical
distribution, VaR calculation becomes a sorting procedure that finds the
threshold scenario xK .
The formula for empirical calculation of Conditional VaR can be derived in two
ways, which shows consistency of CVaR measure.
Z
1
CVaR (X) =
VaR (Xw )d
0
= E[X|X VaR (X)]
K
X
E[X]
1
=
=
p t xt
Pr(X VaR (X))
t=1
PK
PK
p t xt
p t xt
= Pt=1
K
= Pt=1
K
t=1 pt
t=1 pt

10

Bayesian theorem is here (conditioning

In discrete terms of an empirical distri- becomes division), providing a faster
P
bution VaR = xt and d = pt and derivation. E[X] = Tt=1 pt xt is derived
PK
= t=1 pt .
above, and Pr(X VaR (X)) = is
VaR definition.

We see that empirical CVaR (X) ES can be decomposed into a weighted

average of outcomes across scenarios (asset prices xt ). This is a property of a spectral risk measure. Such risk measures can be related to a utility function through
the weights!
For example, instead of probaility weights

p
PK t

t=1

pt

we can use the utility func-

tion pt eT . This choice of allows to implement an exponential decay, where

defines the impact of past observations. Instead of time T , we can use another
variable, such as an economic indicator to stress-test for regimes (e.g., high inflation or VIX levels). That variable yt should be either discretised or normalised so
P
that
pt = 1.
Given that pt are set analytically and xt are empirical observations, this appoach to calculate risk measures (VaR and CVaR) does not require re-pricing or
Monte-Carlo.

Parallels between CVaR and CVA

One-to-one comparision can be drawn between Conditional VaR and Credit

Value Adjustment. Under the risk-neutral measure,
Z T
E[ers PE(s)] dPD
CVAt = (1 R)
t

Integrating over probability (of default) multiplied by the level of exposure is

similar to CVaR calculation method. If default occurs at time t, the amount of
loss is fixed at (1 R)EPE(t)] = VaR
Integration over time should not confuse us because for an empirical distribuP
P
tion, Tt pt = 1 and for CVA Tt pt T . For example, intensity models give
PD = 1 es s for a small time period s, so dPD = s .
11

With the simplication, CVA becomes a sum of exposures multiplied by piecewise constant intensity s . For a single small time period, s ps
T
X

EPEt t '

T
X

xt p t

Given this reduction of CVA to the first moment of the empirical loss distribution, its properties as risk measure are problematic: higher CVA is an indicator of
higher implied probability of default. In order to make a measure of risk comparable to CVaR, the amount of loss, and possibly recovery rate, should vary.

12