F & S Investments:

Understanding Value at Risk

Presented by

Group 6
Isha Tayal (18)
N Md Jaffar (90)
Pavankumar H K (94)
Saad Khan (131)

Case Summary

In March 2007, F&S Investments decided to use

VaR to evaluate new investment strategies.
Evaluate the VaR for existing portfolio and
determine impact of adding two new assets to the
portfolio
F&S was concerned about the potential impact of
ve returns on investors confidence

F&S was considering the addition of new category

assets to its existing portfolio
Existing Portfolio focused on North America based
equities and bonds
New additions
Other developed markets (Western Europe, Japan & Australia)
Equities from emerging markets (Eastern Europe. Middle East, Asian

markets)

To understand the existing portfolio

Returns of past two years were calculated (natural logarithm)
Mean, standard deviation, minimum, maximum and range were calculated
Beta and Sharpe ratio were calculated to obtain understanding of risk
Five-day returns to determine maximum loss in liquidating positions
Compared the actual returns of the portfolio to normally distributed returns

VAR EXISTING PORTFOLIO

Variance-Covariance Method

Return on assets are assumed to be normally

distributed
Returns are assumed to move together in the
future consistently with how they moved in the
past
Values for different confidence intervals are
estimated using mean and standard deviation
from historical data

10% confidence level = -0.00322

5% confidence level = -0.00388
1% confidence level = -0.00518

VAR EXISTING PORTFOLIO

Historical Simulation Method

Orders the observed returns over a specific

period of time from highest to lowest and
uses the bottom 10%, 5%, 1% values to
determine the corresponding confidence
level
10% confidence level = -0.00209
5% confidence level = -0.00334
1% confidence level = -0.00554

VAR PROPOSED PORTFOLIO

Calculated mean, standard deviation,

minimum and maximum values
Assuming 80% existing portfolio 20% new
portfolio
Calculated returns, beta and Sharpe ratio

In order to consider diversification value of

new assets, the correlations of each
portfolios was calculated
Emerging Equities and Existing 0.700
Developed Bond and Existing - -0.082

Q1.

The changes in the prices for the portfolios indicate relative

attractiveness in terms of volatility/stability and return.

The first remarkable difference between developed market

bonds and emerging market equities is fluctuations in price
level.

If one invests in bonds market, the value of investment is

expected to be stable whereas equities market has a lot of
volatility,

Investors cannot predict how much they will earn or loss

unlike bonds whose interest rate doesnt change, so it is
possible to know the amount of revenue expected.

However, if relative value of these assets is taken into

account, it is obvious that emerging market equities have

Q2.

The return that investors may have is more likely to

be higher in equities market than in bond market
even if huge loss is also possible.

But, developed market bond portfolio has also

followed a stationary process which means returns are
steady and parameters such as mean or standard
deviation doesnt change dramatically over time.

Bond portfolio has a trend for returns fluctuating very

close around the mean while returns emerging market
portfolio provides are non-stationary.

Q3.

Q4.

Q5.

VaR tells the maximum loss for a given

confidence interval
At 5% level, the VaR ratio among existing,
emerging and developed markets are:
1:4:0.7 (.39%, 1.55%, .27%)
At 1% level, the VaR ratio among existing,
emerging and developed markets are:
1:4:0.7 (.52%, 2.07%, .36%)
Relative risk of loss increases by 1.3 times
from 5% level to 1% level (2.576/1.96)

Q6.

VaR can be used to set the maximum

allowed loss to avoid down side risk
while
choosing
an
asset
for
investment or building optimum
portfolio

Assets which are used as collateral

can be affected by VaR values.
Higher VaR may lead to higher
haircuts

Q7.

Choose Developed
because

market

bonds

Asset level has been increasing over last 2

years (Exhibit 1)
It gives diversification benefits (cor =-.082)
Return is closer to normal distribution
(Exhibit 4)
Has less VaR compared to existing portfolio
(Exhibit 5)

Q8.

Emerging mkt + Existing Portfolio

Increase in mean returns 54.2%
Marginal increase in Sharpe Ratio from 1.836

to 1.879
58.4% increase in VaR (5% level)

Developed + Existing Portfolio

Decrease in mean returns 12.5%
increase in Sharpe Ratio from 1.836 to 2.006
10.5% decrease in VaR (5% level)

Even though option 1 look attractive

because of higher mean return, risk
adjusted
return
remains
same
(Sharpe ratio). But there is significant
increase VaR
Option 2 has significant increase in
Sharpe ratio and decrease in VaR
So, developed + existing portfolio is
better choice
Also to minimize loss option 2 better

THANK YOU