Value at Risk Methodology

April 2007
Table of Contents

Preface ...................................................................................... 1
A Note about Risk Factors.............................................................. 1
What is a Scenario?...................................................................... 1
Value at Risk (VaR) ...................................................................... 2
Time Horizons............................................................................ 2
Monte Carlo Scenarios .................................................................. 3
The Variance Covariance Matrix ....................................................... 3
Monte Carlo Scenario Generation...................................................... 4
Geometric Brownian Motion Model ................................................... 4
Standard Random Sampling ............................................................ 5
Summary of Parameter Settings ...................................................... 6
Historical Scenario Generation........................................................ 6
Parametric VaR ............................................................................ 7
Examples of Parametric VaR Computation .......................................... 9
Interest Rate Risk ......................................................................... 9
Equity Risk ................................................................................ 10
FX VaR ..................................................................................... 11
Comparison of Risk Methodologies .................................................. 12
 i

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Preface
The Value at Risk Methodology document outlines the various “Risk”
methodologies that are incorporated into the Bloomberg Value at Risk (VAR)
application.

A Note about Risk Factors

A large Part of this document is dedicated to scenarios and scenario generation.
Algorithmics uses a “Full Valuation Methodology” to Theoretically Value every
security we process. This means that security is broken down into its building
blocks of risk, or Risk Factors.

There are three broad Risk Factor classifications:

• Interest Rates−Base Bank and Treasury Rates, Credit Spreads, Sector
Spreads.
• Market Indexes−Major equity indexes, Multi-Factor Model Indexes.
• Exchange Rates−Most major global FX rates.

The specific risk factors are tracked daily and the CLOSING price or rate (for that
particular day) history kept in a time series database. The database is then used
to generate scenarios. The scenarios move the risk factors, which change the
Theoretical Valuation and thus create a Theoretical Profit or Loss.

The time series database contains data for three years of history. This is a
rolling period, in that there are always three years of price/rate history in the time
series database.

What is a Scenario?
A scenario is a factor that is applied to the current risk factor level resulting in a
change in the risk factor value. Subsequently, the security “Theoretical Value” will
be affected. Scenarios can be described as a series of factors applied to current
risk factor levels. Changing the risk factor levels results in a new Value for a
particular security and thus a “Theoretical Profit or Loss” (Theoretical Value
Scenario 1 – Current Value = Theoretical Profit or Loss). The Theoretical
Profit/Loss for an individual security is then sorted for VaR, or simply reported for
sensitivity or stress test purposes.

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Value at Risk (VaR)

There are three different VaR measures within the Algorithmics for Everyone
(A4E) suite:
• Monte Carlo
• Historical
• Parametric.

The first two VaR methodologies are identical, other than they use different
scenario sets. Both methodologies are Non-Parametric, which means that the
profits/losses for each scenario (and each time horizon) are sorted from largest
loss to largest gain. Based on the confidence interval, a particular scenario
profit/loss (in most cases a loss) is reported as the VaR. For example, a 99%
confidence interval with 1000 scenarios will select the 990th worst scenario and
report it as the VaR.

Parametric VaR uses an approximation methodology based on the volatilities

and correlations of the risk factors to compute a map of the instrument’s value to
a particular risk factor associated with it. A simple equation then aggregates the
VaR map into a VaR measure. This will be outlined further later in the document.

Time Horizons
Value at Risk must be associated with a time horizon. A series of profits or
losses does not occur instantaneously, and typically for risk measurement is
measured over a minimum of one day. Depending on the selected scenario set,
there is a one-day horizon available for Historical Simulation and an additional
two- week horizon for Monte Carlo. It is worth noting that the A4E product suite
revalues securities across time accurately, meaning forward interest and FX
rates are computed, and growth rates applied to market indexes. In addition,
using full valuation will capture cash flows from such events as coupon payments
and incorporate them in the valuation at that time point and affect the risk
accordingly.

A time horizon for either the Historical or Monte Carlo scenarios impacts the span
over which historical returns for Risk Factors are computed. Therefore, longer
time horizons would be expected to be more volatile than shorter time horizons.
Consider each scenario to be a factor applied to current risk factor levels.
Different scenario methodologies result in different factors that are applied, but
each scenario generation methodology also has it own way of adjusting the
factor for a time horizon. Where Monte Carlo uses a simulation model that is
described below, Historical scenarios on the other hand, simply aggregate daily

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observed returns into a return over a time period. Parametric approaches simply
scale a daily VaR number (since the historical returns are daily) into a longer
horizon.

Algorithmics uses full forward evolution for the security valuation in the future.
This implies several key points about looking at future time horizons:
• Forward Curve/FX rates used. This means that at any forward time
horizon all rates are evolved, encompassing “rolling down the yield
curve” (interest rate curves) and “interest rate parity” (FX rates)
properties.
• All security cash payments incorporated as fixed income securities will
move towards par.

Monte Carlo Scenarios

There are two stages to Monte Carlo scenario generation:
1. Compute risk factor volatilities and correlations (variance/covariance matrix).
2. Use a variance-covariance (VcV) matrix to generate the actual scenarios, or
factor shifts of current risk factor levels.

Currently in A4E, 1000 Monte Carlo scenarios are used across two time steps:
one day and two weeks.

The Variance Covariance Matrix

A variance-covariance (VcV) matrix is a set of numbers that describes the
relationships within a set of risk factors. Fundamentally, risk factors are treated
as random variables. The time series data for the risk factors and one of three
statistical methods are used to create the covariance matrix.

A covariance matrix has one row and one column for each risk factor. The off-
diagonal elements represent the covariances between risk factors while the
diagonal elements represent the variance of individual risk factors. A covariance
or correlation is a measure of the relation between the values of two risk factors.
A variance or volatility is a measure of the variability of the value of a risk
factor. This standardization ensures compatibility with scenario generation and
parametric VaR computation.

Algorithmics uses a RiskMetrics model to compute the VcV matrix. The

RiskMetrics model is based on the recommendations published by the
RiskMetrics Group and uses an exponentially weighted moving average model.

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The parameters used to compute the VcV Matrix include:

• decay factor = 0.94 (determines how quickly the weighting of past return
data declines)
• k value = 74 (or the number of business days in the past that are used
for estimate).
The decay factor and k value used in the estimation depend on the length of time
into the future to be forecast and the desired accuracy of the predictions. Both
the decay factor and the k value serve similar purposes, to be used to control
sensitivity to more recent events.

Monte Carlo Scenario Generation

Monte Carlo simulation allows you to find solutions to problems that require a
probability analysis. Monte Carlo methods solve highly complex financial
problems, and are frequently used in pricing derivatives, or estimating a
portfolio’s VaR.

The process to generate Monte Carlo Scenarios typically involves three steps:
• Determine the risk factors
• Assign a simulation model for the risk factors
• Produce draws (sample) from the model (representing the actual
scenarios).

Geometric Brownian Motion Model

The simulation model is a Geometric Brownian Motion model that uses the VcV
matrix outlines above. This model is intended to outline how the risk factors will
move across time. Also known as the Black Scholes Model with Zero Drift, this
can be pictured as a random walk in continuous time. The movements in prices
from one day to another are represented as a series of returns. The distribution
of these continuously compounded returns at the end of any finite time interval is
a Log Normal distribution.

Another feature of this model is that the dispersion of the scenarios increase
without bound as simulation time increases. Graphically, this is shown in
Figure 1.

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Figure 1: Sample Paths of a Brownian Motion

Discrete approximation to Brownian motion is used to produce scenarios. This

approximation is based on an important property of Brownian Motion: the
movement of the risk factor between two points in time is normally distributed
with variance proportional to the square root of the elapsed time. Beginning at
time zero, a jump to time 9 would have a variance of 3(sigma)^2, where sigma is
the one-step variance.

Standard Random Sampling

Standard Random Sampling is the simplest sampling technique and can be used
with Monte Carlo scenario generation. With Monte Carlo, the Standard Random
Sampling method is the classic way to use a pseudorandom number generator to
generate a sequence of random variables. Standard Random Sampling draws
values randomly from a uniform distribution until a desired number of scenarios
with a desired number of trigger times have been created. A transformation is
then applied to convert the uniform random variates into random variates that
follow a normal distribution.

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Summary of Parameter Settings

Parameter settings are summarized in Table 1.

Table 1: Summary of Parameter Settings

Parameter Setting Comment
Number of Scenarios 1000 A standard number of scenarios for
Market Risk simulation.
Delta Type Ratio The shift is defined by the ratio of one
value versus the other.
Risk Factor Dates
Covariance Matrix Internally generated All historical risk factor data used to
generate a VcV matrix.
Multi Step Trigger One day, one week, Trigger times correspond to the various
Time Definition two weeks, one investment horizons desired.
month, one quarter.
Simulation Model Geometric Brownian Model of evolution of risk factors.
Motion (see note). Detailed explanation beyond scope of this
document.
Simulation Schema Standard Sampling technique, with no limits on
dimensionality, no prerequisite for
Principal Component Analysis, and is
based on “pseudo-random” numbers.
Decay Factor 0.94 Latest Risk Factor Data weighted heavier
than less recent dates.

Note: Simulation models of this type are also known as stochastic processes
because they specify the (marginal) evolution of a risk factor through time. The
equation of the process implies a distribution for risk factor value at any particular
point in time.

Historical Scenario Generation

This scenario uses a replication sampling method to draw observations directly
from historical market data. This data consists of one full year of values for all the
risk factors. Actual variable shifts and “shocks” are applied to the historical data
and a relative one day change is calculated for each risk factor. The investment
horizon for the scenario is set to one day (making it a one- day holding period).
The return is calculated by comparing the current day values to previous day
values found in the historical sample and applying changes one day at a time to

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re-value the portfolio holdings. This allows a one- day VaR to be calculated (e.g.,
picking the worst 5% of days for 95% VaR).

Historical scenarios are drawn directly from historical market data. When using
historical scenarios as the basis of statistical analyses, the distribution will be
similar to the historical distribution. That is, the future will resemble the past.

When compared to Monte Carlo scenarios, historical scenarios are based on less
restrictive distributional assumptions and are often easier to explain. In fact, the
typical process for generating historical scenarios is simple:
1. Select the risk factors.
2. Track these risk factors over time.
3. Determine a time window that serves as the basis for the scenarios.
4. Calculate returns for the selected risk factors over this time window.
5. Use the returns to create scenarios.

Parametric VaR
The third type of VaR analysis available within A4E is the Parametric VaR. This
type of VaR is not scenario based, rather an approximation made from volatilities
and correlations. The Parametric VaR measure is a statistical risk measure that
calculates the market risk of a portfolio for a specific confidence level. The VaR
gives an indication of a loss with a given probability. The analytic engine uses a
tweaking method to calculate a risk factor (VaR) map from the risk factors
specified in the covariance data files. The tweak is used to approximate a partial
derivative of the instrument, with respect to risk factor node. The tweak controls
the amount the risk factor is shifted when instrument sensitivity is measured. The
Parametric methodology then uses the VaR map to calculate VaR. This
methodology involves analytical measures and is independent of simulation.

For each security a “VaR Map” is computed, using the Theoretical Value and the
data in the VcV files for the risk factors applicable to that particular security.
RiskWatch (the A4E simulation engine) computes the map values by calculating
the delta of an instrument for each risk factor. A risk factor can be an exchange
rate, an equity index, or a bucket on a zero or swap curve in a specific currency,
which is used to shock the RiskWatch curve.

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RiskWatch performs VaR mapping in two main steps:

1. Determine all the risk factors that could affect the value of an instrument.
2. Compute the map value for each factor found in Step 1. Conceptually, each
map value is calculated in the following manner:

Map Value = (Change in Present Value)/(Relative Change in Risk Factor)

This change is a result of the tweaking or moving the relevant curves up one
basis point (0.01 movement for equity indexes).

The general notion of VaR is simply a percentile of the (probabilistic) distribution

of financial losses. More precisely, let the value of a financial instrument, or
portfolio of such, be denoted by V , and the difference of today’s value from the
(random) value at the end of a fixed time horizon be denoted by ∆V . Then VaR,
at the two-sided confidence level α , is defined implicitly through the relation:

1+α
P (− ∆V ≤ VaR) =
2

⎛1+ α ⎞
so that VaR is the ⎜ ⎟ -percentile of the losses, − ∆V . Note that a negative
⎝ 2 ⎠
loss is a positive gain.

In general, exact analytical valuation of VaR is usually intractable. Parametric

approaches involve a first-order numerical approximation to ∆V and a
parametric hypothesis on the joint distribution of the risk factors underlying V .

Specifically, the Parametric model assumes that:

1. V = f ( P1 , P2 ,...., Pn ) where the risk factors, P1 , usually represent prices.
2. ∆V is approximated by the differential, dV = df .
3. The joint distribution of the returns, dPi / Pi , is a multivariate normal, usually
with mean zero. (An exception is Equity VaR, in which there is a growth effect
which implies a non-zero mean.)

Assuming for simplicity that the multivariate mean in the third model assumption
is zero, it follows that dV is a mean-zero normal random variable with variance of
σ 2 dV ; and the approximate equation:

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1+α
P (− dV ≤ VaR) ≈
2

implies that:

VaR ≈ z[(1+α ) / 2 ] • σ dV • dt

Thus the approximate evaluation reduces to the calculation of the variance σ 2 dV

in terms of the variances and covariances of the returns dPi / Pi of the risk
factors Pi . These latter statistical parameters are typically read by RiskWatch
from data files supplied by the Algorithmics Scenario Engine. In RiskWatch, the
∂f ∆f
partial derivatives, , are evaluated numerically as , a process that was
∂Pi ∆Pi
referred to above as tweaking. The resulting numerical gradient vector is called
the VaR map.

In practice, the approximation works reasonably well for linear financial

instruments when the volatilities of the risk factors are of low to moderate size.
For nonlinear instruments such as options, the approximation can be very poor.

Examples of Parametric VaR Computation

There are different ways in which Interest Rate, Equity, or FX VaR is computed
parametrically. For the purpose of illustration in this document, an outline of how
Parametric Interest Rate VaR is computed will be described below.

Interest Rate Risk

The Parametric VaR Calculation uses three inputs for Interest Rates:
1. The VaR Map (as described in Parametric VaR).

( pv1 − pv0)
Mi = • df 0
(df 1 − df 0)

Where “pv0” = Security Present Value “untweaked”, and 1 is “tweaked”

“df0” = Discount Factor at that particular time point

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2. Yield and Price Volatility, from the Variance Covariance Matrix.

⎛ ⎛ dy ⎞
2
⎞
Yield Volatility = σ 2 yi • dt = E ⎜ ⎜⎜ i ⎟⎟ ⎟
⎜ ⎝ yi ⎠ ⎟
⎝ ⎠
Price Volatility = σ pi = (D A )i • yi • σ yi

3. Risk Factor correlation, from the Variance Covariance Matrix.

Let the two risk factors in question be “i” and “j”:

⎛ dy dy j ⎞
ρ ij = E ⎜⎜ i • ⎟ / (σ yi • σ yj )
y y ⎟
⎝ i j ⎠

With these inputs we can represent the Parametric VaR, for an specific
unwind period:

( η = SDF • UnwindPeriod , where SDF=Standard Deviation Factor = Z [(1+α ) / 2 ]

and α represents the confidence interval) the Parametric VaR can be

represented as:

n n
VaR = η • ∑∑ M σ
i =1 j =1
i pi ρ ij M j σ pj

Equity Risk
With typical equity models, the change in the Equity Value, V, is represented
through a change in a Market Index Price, Pm.

In this case the equity VaR map is represented by:

∂V
M = Pm
∂Pm

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Subsequently, the VaR is computed:

VaR = η • M • σ m

In the case of a Multi-Factor equity model, the VaR Map has multiple sensitivities
to multiple market indexes. The VaR calculation is then changed by adding a
term to represent the correlation of the various indexes, similar to the equation
above for interest rates. Note that there is no “specific” risk included in the
parametric equity VaR Calculation.

FX VaR
The main difference between the FX VaR and Interest Rate VaR is in the VaR
Map procedure. To generate the VaR map for FX sensitive securities, the FX
rates are tweaked:

∂f I pv1 = pv0
Mi = r = • spot 0
∂ri I i
spot1 − spot 0

Where spot0 is the current exchange rate from the foreign currency to the
currency of the security, that is spot0= ri I

Once the VaR map is created, the VaR looks very similar to the Interest Rate
VaR:

n n
VaR = η • ∑∑ M σ
i =1 j =1
i pi ρ ij M j σ pj

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Comparison of Risk Methodologies

A comparison of risk methodologies is shown in Table 2.

Table 2: Comparison of Risk Methodologies

Topic Monte Carlo Historical Parametric
Time Series Estimation period = One year of Estimation period =
74 days (in the VcV scenarios. 74 days (in the VcV
matrix). matrix).
Normality Lognormal None
Assumption Distribution.
Time Series Exponentially Equally weighted Exponentially
Weights weighed, meaning returns determine weighed, meaning
recent results have the scenarios. recent results have
larger impact on larger impact on
VcV matrix. VcV matrix.
Time Horizon Geometric Brownian Observed daily Daily results scaled
Methodology Motion outlines risk returns sampled by square root of
factor movement and concatenated to the unwind period.
through time. form time horizon
factor.
Security Forward Forward Curves, FX Forward Curves, FX Scaling is does not
Evolution across rates used, all cash rates used, all cash encompass forward
time horizon. payments payments curve evolution or
incorporated. incorporated. cash payments.
Equity Specific Yes, residual Yes, residual No
Risk Simulated? volatility from multi volatility from multi
factor model used factor model used
as basis for specific as basis for specific
risk (normal risk (normal
assumption of assumption of
specific risk). specific risk).

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