A PROJECT REPORT ON

Time Scaling of Risk and the Square Root of Time Rule

Under the guidance of Prof. Haipeng Xing

Submitted by: Tripti Ahuja (107923682) Graduate Student Dept. of Applied Mathematics and Statistics Stony Brook University

Table of Contents

Table of Contents........................................................................................................ii LIST OF FIGURES:........................................................................................................ ii INTRODUCTION..........................................................................................................iii OVERVIEW..................................................................................................................v Brownian motion:.................................................................................................... v Jump Process:.......................................................................................................... v RESULTS...................................................................................................................viii DISCUSSION OF RESULTS...........................................................................................x CONCLUSION..............................................................................................................x REFERENCES............................................................................................................ xiv

LIST OF FIGURES:
Figure 1: Relative error in SRTR with partial wealth wipeout and zero drift..............xii Figure 2: Relative error in SRTR with full wealth wipeout and zero drift..................xiii Figure 3: Relative error in SRTR, with full wealth wipeout and positive drift............xiii

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INTRODUCTION
Value at Risk (VaR), defined as a worst case scenario in terms of losses on a typical day, is a popular measure of tail risk management that is not only recommended by banking supervisors (see the Basel Committee on Banking Supervision,1996), but is also widely used throughout the financial industry, including by banks and investment funds. It is even used by nonfinancial corporations in supervising inhouse financial risks following the success of the J.P. Morgan Risk Metrics system. Operationally, tail risk such as VaR is generally assessed using a 1-day horizon, and short horizon risk measures are converted to longer horizons. A common rule of thumb, borrowed from the time scaling of volatility, is the square-root-of-time rule (hereafter the SRTR), according to which the time-aggregated financial risk is scaled by the square root of the length of the time interval, just as in the BlackScholes formula where the T-period volatility is given by . Regulators also advocate the routine use of the SRTR. For example, to avoid duplication of risk measurement systems, financial institutions are allowed to derive their two-week VaR measure by scaling up the daily VaR by SRTR; see, for example, the Basel Committee on Banking Supervision (1996). In fact, horizons of up to a year are not uncommon; many banks link trading volatility measurement to internal capital allocation and risk-adjusted performance measurement schemes, which rely on annual volatility estimates by scaling 1-day volatility by If the SRTR is to serve as a good approximation of all quantiles and horizons, it not only requires the iid property of zero-mean returns, but also that of the Normality of the returns. These pre-assumptions are far from being realized in real world financial asset returns. For example, if the distributions of the changes in the value of the portfolio are self-similar or in the presence of volatility clustering where the common practice of converting 1-day volatility estimates to h-day estimates by SRTR scaling is inappropriate and yields overestimates of the variability of long horizon volatility. Researchers have long realized that financial time series exhibit certain unusual and extreme violent movements, known as jumps (systemic risk) and modeled using jump diffusions that create discontinuous sample paths. In particular overall time scaling fails for many popular processes, such as GARCH process, stochastic volatility processes or jump processes. The natural dgp for returns prone to systemic risk is the jump diffusion, with its mostly continuous returns but with some rare, but very destructive, systemic events. Therefore, the SRTR when applied to above, can lead to underestimation of risk, and can do so by a very substantial margin. The study discusses how the underlying jumps influence the SRTR approximation of longer-term tail risks. It gives an insight into how Brownian and Poisson terms interact and over which horizons one of the terms dominate the other. Also, it is shown that SRTR tends to underestimate the time-aggregated VaR and the

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downward bias deteriorates with the time horizon owing to the existence of negative jumps.

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OVERVIEW
The two basic building blocks of every jump-diffusion model are the Brownian motion (the diffusion part) and the Poisson process (the jump part). Brownian motion: A stochastic process St is said to follow a GBM if it satisfies the following stochastic differential equation (SDE):

where Wt is a Wiener process or Brownian motion and ('the percentage drift') and ('the percentage volatility') are constants. When is zero in the above equation, it becomes Brownian motion. Jump Process: The homogeneous Poisson process is one of the most well-known Lvy processes. This process is characterized by a rate parameter , also known as intensity, such that the number of events in time interval (t, t + ] follows a Poisson distribution with associated parameter . This relation is given as:

where N(t + ) N(t) is the number of events in time interval (t, t + ]. A homogeneous Poisson process is characterized by its rate parameter , which is the expected number of "events" or "arrivals" that occur per unit time. For financial applications, it is of little interest to have a process with a single possible jump size. The compound Poisson process is a generalization where the waiting times between jumps are exponential but the jump sizes can have an arbitrary distribution. A compound Poisson process with rate > 0 and jump size distribution G is a continuous-time stochastic process given by

where, is a Poisson process with rate , and are independent and identically distributed random variables, with distribution function G, which are also independent of The Poisson process shares with the Brownian motion the very important property of independence and stationarity of increments, that is, for every t > s the increment is independent from the history of the process up to time s and has the same law as . v

Combining a Brownian motion with drift and a compound Poisson process, we obtain the simplest case of a jump diffusion a Levy process (refer-which sometimes jumps and has a continuous but random evolution between the jump times.)

We assume that wealth is governed by a jump diffusion process, where in the absence of a jump, the evolution of wealth follows a geometric Brownian motion. A Poisson shock occurs at some random time s, at which time a fraction (1- ) [0, 1] of the portfolio value is wiped out. The recovery rate d is constant and deterministic for simplicity. These dynamics can be written as (here refers to the wealth at time t prior to any Poisson jumps that might occur at time t):

Here is a Brownian motion, is a constant and deterministic drift parameter and is a constant and deterministic diffusion parameter different from zero. The Poisson process driving the jumps is denoted by q, with constant and deterministic intensity . The units of are average number of years between systemic events. and are stochastically independent processes. Applying Itos Lemma to the function and integrating from time 0 to t we get the expression for the wealth levels

We fix the basis period k to a unit of time, e.g., one day or k = 1/250, and analyze the VaR over a horizon of . The relevant return is then

Notice that the distribution of X(t, t + ) is independent of information available at time t: the underlying returns process is iid and volatilities scale with the squareroot-of-time rule. Call the maximum number of shocks possible under the dgp as I. For I , The VaR( can be deduced as follows: at the -level with a horizon

where exist.When

With

a solution VaR(

to above always

the solution exists if the probability of crash is not too high, i.e

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In order to show that the SRTR over-or-underestimates the true VaR, we need to compare the proposed approximate VaR number with the true VaR number. For this, we define the (relative) underestimation (or correction) function:

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RESULTS
1. In absence of Poisson jumps, . = 0, VaR is calculated as:

Case 1: when drift is zero, i.e

The SRTR applies in this case. Case 2: when drift is non-zero, i.e

The SRTR leads to overestimation of risk.

2. In presence of Poisson jumps,

, VaR is calculated as

When

0 and

When

Case 1 : when

0,

Case 2: when

Case 3: when

(but sufficiently small) viii

The SRTR leads to underestimation of risk in all the three cases.

Various numerical simulations are performed where the drift and volatility are calibrated to historical annualized values of the S&P-500 index, 5.48% and 15.84% respectively. In the first set of numerical simulations we follow standard practice in the risk management industry and assume the drift is zero. Tables 1 and 2 show the VaR from using the square-root-of-time rule( as well as the correct VaR (VaR( )).The values in the table show that longer holding periods or higher crash probabilities imply that the SRTR becomes increasingly inaccurate. VaR values in table 3 uses the same model parameters as table 1, with the exception of the drift which is a positive value. Looking at figure 1, it becomes clear that relative risk error arising from SRTR are roughly the same for any potential losses above 25% and this is true for all levels of . Figures 2 & 3 show the relative error for a range of holding periods and crash frequencies with zero and positive drift respectively.

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DISCUSSION OF RESULTS
From the results given above, it is clear that SRTR applies when Poisson jumps are zero and there is no drift. For all other cases when finite Poisson jumps are considered, the SRTR rules lead to underestimation of risk. The two main cases that need to be analyzed: and .For , the initial worsening of the underestimation as the horizon is extended eventually will give way to a bettering of the underestimation. When , and the drift is zero, the degree of underestimation is positive. Losses worse than VaR can occur and depends upon how Brownian and Poisson terms interact. Over longer horizons, the two terms interact non-lineraly and the Poisson term dominates the drift term. Longer holding periods or higher crash probabilities imply that the SRTR becomes increasingly inaccurate. However, when the drift is strictly positive and known, the SRTR still underestimates the risk as long as the drift term is sufficiently small. The error is worse the larger the likelihood of a systemic event and the larger the horizon of extrapolation. The emphasis is on the simple case when and the same argument as above holds true.

CONCLUSION
Scaling with the SRTR is simple and has been widely employed in practice, and, even in some instances is required by regulation, as a tool for approximating longer horizon tail risks in the financial industry. The ugly facts based on the real world asset returns make the optimistic pre-assumptions on which SRTR scaling is built far from credible, and thus the performance of SRTR scaling is doubtful. This study considers the implications of time scaling quantiles of return distributions by the square-root-of-time when the underlying stochastic process is jump diffusion. Results indicate that an application of the square-root-of-time rule to the forecast of quantile based risk estimates (such as value-at-risk) when the underlying data follows a jump-diffusion process is bound to provide downward biased risk estimates. Furthermore, the bias increases at an increasing rate with longer holding periods (at least up to some remote horizon), larger jump intensities or lower quantile probabilities, where the Poisson terms interact non-linearly with the Brownian term. An exception may be at the 10-day horizon where the underestimation arising from the systemic component has historically been counterbalanced by the overestimation induced by the drift term.

Variable Value 0.1584 0.0000 0.0100 0.0000 k 0.0040

Expected Crash Time in Years (1/) Measure VaR(10) sqrt(10)*VaR(1) Ratio VaR(20) sqrt(20)*VaR(1) Ratio 10 79.5251 74.1778 1.0721 128.6110 104.9033 1.2260 20 76.2884 73.9361 1.0318 112.4655 104.5615 1.0756 30 75.3677 73.8565 1.0205 109.2893 104.4489 1.0463 40 74.9304 73.8169 1.0151 107.8881 104.3929 1.0335 50 74.6748 73.7932 1.0119 107.0959 104.3593 1.0262

Table 1 : 1 %, 10 and 20 day VaR on a $1000 portfolio , varying (1/)

Variables Value 0.1584 0.0000 0.0100 0.7500 k 0.0040 0.0400

Holding Period in Days Measure VaR(neta) sqrt(neta)*VaR(1) Ratio 10 78.8703 78.5556 1.0040 20 111.8091 111.0943 1.0064 30 137.191 136.0622 1.0083 40 158.6612 157.1111 1.0099 50 177.6315 175.6556 1.0112 60 194.8262 192.4210 1.0125

Table 2: 1 % VaR on a $1000 portfolio, varying

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Variables Value 0.1584 0.0548 0.0100 0.0000 k 0.0040

Expected Crash Time in Years (1/) Measure VaR(10) sqrt(10)*VaR(1) Ratio VaR(20) sqrt(20)*VaR(1) Ratio 10 77.3331 73.4847 1.0524 124.2270 103.9230 1.1954 20 74.0964 73.2430 1.0117 108.0815 103.5812 1.0434 30 73.1757 73.1634 1.0002 104.9053 103.4686 1.0139 40 72.7384 73.1237 0.9947 103.5041 103.4126 1.0009 50 72.4828 73.1000 0.9916 102.7119 103.3790 0.9935

Table 3: 1 %, 10 and 20 day VaR on a $1000 portfolio , varying (1/)

Figure 1: Relative error in SRTR with partial wealth wipeout and zero drift

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Figure 2: Relative error in SRTR with full wealth wipeout and zero drift

Figure 3: Relative error in SRTR, with full wealth wipeout and positive drift

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REFERENCES
[1] Basel Committee on Banking Supervision, 1996. Overview of the Amendment to the Capital Accord to Incorporate Market Risk. [2] Danielsson, J., Zigrand, J.-P., 2005. On time-scaling of risk and the square-root-of-time rule. Mimeo, <www.riskresearch.org>. [3] Engle, R.F., 1982. Autoregressive conditional heteroscedasticity with estimates of the variance of United Kingdom inflation. Econometrica 50, 329 [4] Diebold, F., Hickman, A., Inoue, A., Schuermann, T, 1997. Converting 1-day volatility to h day volatility: Scaling by is worse than you think. Discussion Paper Series, No. 97-34, Wharton [5] Menkens, Olaf:2005. Value at Risk and Self-Similarity [6] Merton, R.C., 1976. Option pricing when the underlying stock returns are discontinuous. Journal of Financial Economics 5, 125144. [7] Merton, R., 1981. On estimating the expected return on the market: An exploratory investigation. Journal of Financial Economics 8, 323361. [8] Pan, J., 2002. The jump-risk premia implicit in options: evidence from an integrated time-series study. Journal of Financial Economics 63, 350. [9] Shreve, S.,Steven, 2004.Stochastic Calculus for Finance II. [10] Tankov,P.,Voltchkova,E., 2009.Jump-diffusion models: a practitioners guide [11] Wang, J.N.,Yeh,J.H, Cheng, N.Y.,2010. How Accurate is the Square-root-of-time Rule at Scaling Tail Risk: A Global Study.

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