Value at Risk

By A.V. Vedpuriswar

June 14, 2014

Introduction

VAR tells us the maximum loss a portfolio may suffer

at a given confidence interval for a specified time
horizon.
If we can be 95% sure that the portfolio will not suffer
more than $ 10 million in a day, we say the 95% VAR
is $ 10 million.

2
Computing Value at Risk

VaR is the product of :

Value of portfolio
Z factor ( depends on confidence level)
Volatility
Time ( VaR scales in proportion to square root of
time)

3
Computing Value at Risk

The usual practice is to calculate daily volatility by

observing the daily opening and closing prices of the
portfolio over a period of time, say 6 months.
Then we obtain the volatility for the actual period under
consideration by multiplying by the square root of the
time.
Thus the volatility for 5 trading days will be that for one
day multiplied by 5.

4
How Banks disclose VaR

5
VaR at UBS

Ref : Company Annual report 6

VaR at UBS

Ref : Company Annual report 7

VaR at UBS

Ref : Company Annual report 8

VaR at UBS

Ref : Company Annual report 9

VaR at UBS

Ref : Company Annual report 10

VaR at Credit Suisse

Ref : Company Annual report 11

VaR at Credit Suisse

Ref : Company Annual report 12

VaR at Goldman Sachs

Ref : Company Annual report 13

Problem
Average revenue = $5.1 million per day
Total no. of observations = 254. Std dev = $9.2 million
Confidence level = 95%
No. of observations < - $10 million = 11
No. of observations < - $ 9 million = 15
Find 95% VAR.

Solution
The point such that the no. of observations to the left = (254) (.05) =
12.7
(12.7 11) /( 15 11 ) = 1.7 / 4 .4
So required point = - (10 - .4 x 1) = - $9.6 million
VAR = E (W) (-9.6) = 5.1 (-9.6) = $14.7 million
If we assume a normal distribution,
Z at 95% ( one tailed) confidence interval = 1.645
VAR = (1.645) (9.2) = $ 15.2 million 14
Problem

The VAR on a portfolio using a one day time horizon is

USD 100 million. What is the VAR using a 10 day
horizon ?
Solution
Variance scales in proportion to time.
So variance gets multiplied by 10
And std deviation by 10
VAR = 100 10 = (100) (3.16) = 316
(N2 = 12 + 22 .. = N2)
Note; This approach is valid only when the daily
variances are independent.

15
Problem

If the daily VAR is $12,500, calculate the weekly,

monthly, semi annual and annual VAR. Assume 250
days and 50 weeks per year.
Solution
Weekly VAR (12,500) (5)
27,951
Monthly VAR ( 12,500) (20)
55,902
Semi annual VAR (12,500) (125)
139,754
Annual VAR (12,500) (250)
197,642

16
Variance Covariance Method

17
Problem
A fund has a portfolio consisting of 40% fixed income and
60% equity. The estimated 95% annual VAR assuming 250
trading days for the entire portfolio was $ 1,367,000 based
on the portfolios market value of $ 12,500,000. The
correlation between bond and stock returns is 0.The
annual loss on the equity part of the portfolio is expected
to exceed $ 1,153,000 5% of the time.
What will be the daily expected loss that will be exceeded
5 % of the time for the bond portfolio?
Solution
1,367,000^2 = 1,153,000^2 + x^2
X = $ 734,357
Daily VAR = 734357/250
= 46,445 18
Problem
Consider a bond position of $ 10 million, a modified
duration of 3.6 years and an annualized bond volatility
of 2%.Calculate the 10 day 99% VAR assuming 252
business days in a year.

Solution
10 day volatility = .02X(10/252)=.003984
So 99% VAR = 2.33 X 3.6 X 10,000,000 X .003984
= $ 334,186

19
Problem
Consider a position consisting of a $100,000 investment in asset A and a
$100,000 investment in asset B. Assume that the daily volatilities of both
assets are 1% and that the coefficient of correlation between their
returns is 0.3. What is the 5-day 99% VaR for the portfolio?

Solution
The standard deviation of the daily change in the investment in each
asset is $1,000. The variance of the portfolios daily change is
1,0002 + 1,0002 + 2 x 0.3 x 1,000 x 1,000 = 2,600,000
The standard deviation of the portfolios daily change is $1,612.45.
The standard deviation of the 5-day change is
1,612.45 x 5 = $3,605.55
From the tables of N(x) we see that Z = 2.33.
The 5-day 99 percent value at risk is therefore 2.33 x 3,605.55 =
$8,401.

Ref : John C Hull, Options, Futures and Other Derivatives 20

Problem

We have a portfolio of $10 million in shares of Microsoft.

We want to calculate VAR at 99% confidence interval over
a 10 day horizon. The volatility of Microsoft is 2% per day.

Solution
= 2% = (.02) (10,000,000) =
$200,000
Z (p = .01) = Z (p =.99) = 2.33
Daily VAR = (2.33) (200,000) = $ 466,000
10 day VAR = 466,000 10 = $
1,473,621

Ref : John C Hull, Options, Futures and Other Derivatives 21

Problem

Consider a portfolio of $5 million in AT&T shares with a

daily volatility of 1%. Calculate the 99% VAR for 10
day horizon.
Solution
= 1% = (.01) (5,000,000) = $ 50,000
Daily VAR = (2.33) (50,000) = $ 116,500
10 day VAR = $ 116,500 10 = $ 368,405

Ref : John C Hull, Options, Futures and Other Derivatives

22
Problem
Now consider a combined portfolio of AT&T and Microsoft
shares. Assume the returns on the two shares have a
bivariate normal distribution with the correlation of 0.3.
What is the portfolio VAR.?
Solution
2 = w12 12 + w22 22 + 2 w1 w2 1 2
= (200,000)2 + (50,000)2 + (2) (.3) (200,000)
(50,000)
= 220,277
Daily VAR = (2.33) (220,277) = 513,129
10 day VAR = (513,129) 10 = $1,622,657
Effect of diversification = (1,473,621 + 368,406)
(1,622,657)
23

Ref : John C =
Hull, Options, Futures and Other Derivatives
219,369
Problem

Consider a portfolio made up of 5 year 5 % coupon

government bonds. The bonds are trading at $ 100. The
historical annual volatility is 1 %. Expected YTMs are
normally distributed with zero mean and volatility of 1%.
Calculate the 95% one year VAR.

Solution
Worst YTM = actual YTM + 1.65 x Volatility
= 5 + 1.65 x 1 = 6.65%
If YTM is 6.65%, bond price will be 93.1708
So the VAR is 100-93.17 = $ 6.83

24
Problem
Consider the following single bond of $10 million, a modified
duration of 3.6 yrs and annualized yield of 2%.
Calculate the 10 day holding period VaR of the position with
a 99% confidence interval, assuming there are 252 days in
a year.
Solution
VAR = $10,000,000* 0.02*3.6* 10/252 * 2.33 = $334,186

25
Problem
Assume that a risk manager wants to calculate VAR for an
S&P 500 futures contract using the historical simulation
approach. The current price of the contract is 935 and the
multiplier is 250. Given the historical price data shown
below for the previous 300 days, what is the VAR of the
position at 99% using the historical simulation
methodology?
Returns: -6.1%,-6%,-5.9%,-5.7%, -5.5%, -5.1%..........4.9%,
5%, 5.3%, 5.6%, 5.9%, 6%
Solution
The 99% return among 300 observations would be the 3rd
worst observation among the returns.
Among the returns given above -5.9% is the 3rd worst
return, the 99% VAR for this position is therefore
(935)*250* (0.059) = $13,791. 26
Problem mathewdo [printed: ____] [saved: May 31, 2007 6:24 PM] P:\WIP\310507\AV Vedpuriswar_Becoming a manager_310507_1408_v1.1.ppt

Consider the portfolio of an American trader with two foreign

currencies, Canadian dollar and euro. These two currencies
are uncorrelated and have a volatility against the dollar of
5% and 12% respectively. The portfolio has $2 million
invested in CAD and $1 million in Euro. What is the portfolio
VAR at 95% confidence level?
Solution
Variance of the portfolio return
= {(2 (.05)}2 + {(1) (.12)}2 =.01 + .0144 = .0244
Std devn = .0244 = $ .156205 million
VAR = (1.65) (156,205) = $257,738
VAR for Canadian dollar part = $ (1.65) (.05) (2) million
= $165,000
VAR for Euro part = $ (1.65) (.12) (1) million
= $ 198,000
Undiversified VAR = $ 363,000
27

Thus the diversified VAR is significantly lower.

 mathewdo [printed: ____] [saved: May 31, 2007 6:24 PM] P:\WIP\310507\AV Vedpuriswar_Becoming a manager_310507_1408_v1.1.ppt

Problem

Suppose we increase the Canadian dollar position by

$10,000. What is the marginal VAR?

Solution
Variance = {(2.01) (.05)}2 + {(1) (.12)}2=.0101 + .
0144= .0245
= .0245 = $.1565 million
VAR = (1.65) (156,500) = $ 258,225
Marginal VAR = 258,225 257,738
= $ 487

28
Problem
An American trader owns a portfolio of options on the US dollar-sterling
exchange rate. The delta of the portfolio is 56.0. The current exchange
rate is $/ 1.5000. Derive an approximate linear relationship between
the change in the portfolio value and the percentage change in the
exchange rate. If the daily volatility of the exchange rate is 0.7%,
estimate the 10-day 99% VaR.

Solution
The approximate relationship between the daily change in the portfolio
value, P, and the daily change in the exchange rate, S, is P = 56 S
For a unit change in , $ will change by 1.5. It follows that
P = 56 x 1.5 x
Or P = 84 x
The standard deviation of x equals the daily volatility of the exchange
rate, or 0.7 percent.
The standard deviation of P is therefore 84 x 0.007 = $ 0.588.
So the 10-day 99 percent VaR for the portfolio is
0.588 x 2.33 x 10 = $ 4.33 for an investment of 1. 29

Ref : John C Hull, Options, Futures and Other Derivatives

Problem
Some time ago a company entered into a forward contract to buy 1 million for $1.5
million. The contract now has 6 months to maturity. The daily volatility of a 6-
month zero-coupon sterling bond (when its price is translated to dollars) is 0.06%
and the daily volatility of a 6-month zero-coupon dollar bond is 0.05%. The
correlation between returns from the two bonds is 0.8. The current exchange rate is
$/ 1.53. Calculate the standard deviation of the change in the dollar value of the
forward contract in 1 day. What is the 10-day 99% VaR? Assume that the 6-month
interest rate in both sterling and dollar is 5% per annum with continuous
compounding.

Solution
The contract is a long position in a sterling bond plus a short position in a dollar
bond.
The value of the sterling bond is 1.53e-0.05x0.5 or $1.492 million.
The value of the dollar bond is 1.5e-0.05x0.5 or $1.463 million.
The variance of the change in the value of the contract in one day is :
1.4922 x 0.00062 + 1.4632 x 0.00052 2 x 0.8 x 1.492 x 0.0006 x 1.463 x 0.0005
= 0.000000288 30

Ref : John C Hull, Options, Futures and Other Derivatives

Problem

Consider the contract on the dollar/euro exchange rate

(EC) traded on the CME. The notional amount is
125,000 Euros. Assume that the annual volatility is 12%
and the current price is $1.05 per Euro. Find daily VAR
at 99% confidence level.

Solution
VAR = (2.33) [(.12) / 252] (125,000 1.05)
= $ 2310

31
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Problem

Consider a portfolio with a one day VAR of $1 million.

Assume that the market is trending with an auto
correlation of 0.1. Under this scenario, what would you
expect the two day VAR to be?
Solution
V2 = 22 (1 + )
= 2 (1)2 (1 + .1) = 2.2
V = 2.2 = 1.4832

32
Auto correlation over longer periods
Consider a period of 5 days.
We assume the first days movement will have an
impact on the second day's movement through the
correlation coefficient.
The first days movement will affect the third days
movement through the square of the correlation
coefficient and so on.
Then the combined variance will be:

2 + 2 + 2 + 2 + 2 + (2) () 2 + (2) ()2 2 + (2)

()3 2 + (2) ()4 2 + (2) () 2 + (2) ()2 2 + (2) ()3 2
+ (2) () 2 + (2) ()2 2 + (2) () 2
= 5 2 + (8) () 2 + (6) ()2 2 + (4) ()3 2 + (2) ()4 2
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Problem
Consider a portfolio with standard deviation of daily returns
of 0.1 and autocorrelation of 0.3. Calculate the 5 day
volatility.

Solution
= 0 .1; = .3
Variance = (5) (.1)2 + (4) (2) (.3) (.1)2
+ (3) (2) (.3)2 (.1)2 + (2) (2) (.3)3 (.1)2
+ (2) (.3)4 (.1)2
= .05 + .024 + .0054 + .00108 + .000162
= .080642
Volatility = .284

34
Monte Carlo Simulation

35
What is Monte Carlo VAR?

The Monte Carlo approach involves generating many

price scenarios (usually thousands) to value the assets
in a portfolio over a range of possible market
conditions.
The portfolio is then revalued using all of these price
scenarios.
Finally, the portfolio revaluations are ranked to select
the required level of confidence for the VAR calculation.

36
Generate Scenarios

The first step is to generate all the price and rate

scenarios necessary for valuing the assets in the
relevant portfolio, as well as the required correlations
between these assets.
There are a number of factors that need to be
considered when generating the expected
prices/rates of the assets:
Opportunity cost of capital
Stochastic element
Probability distribution

37
Opportunity Cost of Capital

A rational investor will seek a return at least equivalent

to the risk-free rate of interest.
Therefore, asset prices generated by a Monte Carlo
simulation must incorporate the opportunity cost of
capital.

38
Probability Distribution
Monte Carlo simulations are based on random draws
from a variable with the required probability
distribution, usually the normal distribution.
The normal distribution is useful when modeling market
risk in many cases.
But it is the returns on asset prices that are
normally distributed, not the asset prices themselves.
So we must be careful while specifying the distribution.

39
Calculate the Value of the Portfolio
Once we have all the relevant market price/rate
scenarios, the next step is to calculate the portfolio value
for each scenario.
For an options portfolio, depending on the size of the
portfolio, it may be more efficient to use the delta
approximation rather than a full option pricing model
(such as Black-Scholes) for ease of calculation.
(Option) = (S)
Thus the change in the value of an option is the product
of the delta of the option and the change in the price of
the underlying.

40
Other approximations
There are also other approximations that use delta,
gamma () and theta () in valuing the portfolio.
By using summary statistics, such as delta and gamma,
the computational difficulties associated with a full
valuation can be reduced.
Approximations should be periodically tested against a
full revaluation for the purpose of validation.
When deciding between full or partial valuation, there is
a trade-off between the computational time and cost
versus the accuracy of the result.
The Black-Scholes valuation is the most precise, but
tends to be slower and more costly than the
approximating methods.
41
Reorder the Results

After generating a large enough number of scenarios and

calculating the portfolio value for each scenario:
the results are reordered by the magnitude of the
change in the value of the portfolio (portfolio) for each
scenario
the relevant VAR is then selected from the reordered list
according to the required confidence level

If 10,000 iterations are run and the VAR at the 95%

confidence level is needed, then we would expect the
actual loss to exceed the VAR in 5% of cases (500).
So the 501st worst value on the reordered list is the
required VAR.
Similarly, if 1,000 iterations are run, then the VAR at the
95% confidence level is the 51st highest loss on the 42

reordered list.
Formula used typically in Monte Carlo for stock
price modelling

43
Advantages of Monte Carlo

We can cope with the risks associated with non-linear

positions.
We can choose data sets individually for each variable.
This method is flexible enough to allow for missing
data periods to be excluded from the VAR calculation.
We can incorporate factors for which there is no actual
historical experience.
We can estimate volatilities and correlations using
different statistical techniques.

44
Problems with Monte Carlo

Cost of computing resources can be quite high.

Speed can be slow.
Random Numbers may not be all that random.
Pseudo random numbers are only a substitute for
true random numbers and tend to show clustering
effects.
Monte Carlo often assumes normal distribution.
But it can be performed with alternative distributions.
Results (value at risk estimate) depend critically on
the models used to value (often complex) financial
instruments.

45
Historical Simulation

46
Introduction
Unlike the Monte Carlo approach, it uses the actual
historical distribution of returns to simulate the VAR of
a portfolio.
Real data plus ease of implementation, have made
historical simulation a very popular approach to
estimating VAR.
Historical simulation avoids the assumption that
returns on the assets in a portfolio are normally
distributed.
Instead, it uses actual historical returns on the
portfolio assets to construct a distribution of potential
future portfolio losses.
This approach requires minimal analytics.
All we need is a sample of the historic returns on the 47
Steps

Collect data
Generate scenarios
Calculate portfolio returns
Arrange in order.

48
 % Returns Frequency Cumulative
Frequency
- 16 1 1
- 14 1 2
- 10 1 3
-7 2 5
-5 1 6
-4 3 9
What is VAR -3 1 10
(90%) ? -1 2 12
0 3 15
1 1 16
2 2 18
4 1 19
6 1 20
7 1 21
8 1 22
9 1 23
11 1 24
12 1 26
14 2 27
18 1 28
21 1 29
23 1 30

10% of the observations, i.e, (.10) (30)

= 3 lie below -7
So VAR = -7 49
Advantages and Disadvantages of Historical
simulation

Advantages Disadvantages
Simple Reliance on the past
No normality Length of estimation
assumption period
Non parametric Weighting of data

50
Comparison of different VAR modeling
techniques

51
Simulation vs Variance Covariance methods
Simulation approaches are preferred by global banks
due to:
flexibility in dealing with the ever-increasing range of complex
instruments in financial markets
the advent of more efficient computational techniques in recent
years
the falling costs in information technology

However, the variance-covariance approach might be

the most appropriate method for many smaller firms,
particularly when:
they do not have significant options positions
they prefer to outsource the data requirement component of
their risk calculations to a company such as RiskMetrics
significant savings can often be made by using outsourced
volatility and correlation data, compared to internally storing the
daily price histories required for simulation techniques
52
Model Validation

53
Basel Committee Standards (1)

Banks that prefer to use internal models must meet,

on a daily basis, a capital requirement that is the
higher of either:
the previous day's value at risk
the average of the daily value at risk of the preceding 60
business days multiplied by a minimum factor of three

VAR must be computed on a daily basis.

A one-tailed confidence interval of 99% must be used.
The minimum holding period should be 10 trading
days .
The minimum historical observation period should be
one year.
54
Basel Committee Standards(2)

Banks should update their data sets at least once every

three months.
Banks can recognize correlations within broad risk
categories.
Provided the relevant supervisory authority is satisfied
with the bank's system for measuring correlations , they
may also recognize correlations across broad risk factor
categories.
Banks' internal models are required to accurately capture
the unique risks associated with options and option-like
instruments.
The Basel Committee has also specified qualitative factors
that banks must meet before they are permitted to use
internal models. 55
Basel Committee Standards(3)

The Basel Committee prescribes an increase in capital

requirements if, based on a sample of 250 observations
(a one-year observation period), the VAR model
underpredicts the number of exceptions (losses
exceeding the 99% confidence level).
For such purposes, three 'zones' have been
distinguished by the Committee.
Green Zone : 0-4 exceptions
Yellow zone : 5-9 exceptions
Red zone : 10 or more exceptions

56
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Problem

Based on a 90% confidence level, how many

exceptions in back testing a VAR model should be
expected over a 250 day trading year?

Solution
10% of the time loss may exceed VAR
So no. of observations = (.10) (250)
= 25

57
Problem

We are currently feeding a model with 600 days of data.

The VAR confidence level is 99%. Nine exceptions are
observed. Should we reject the model? Suppose it had
been 12. Would we reject the model?
Solution
1 Binomdist (8, 600, .01, True) = .152
So we cannot reject the model at 5% significance
level.
1 Binomdist (11, 600, .01, True) = .019
So we would reject the model at 5% significance
level

Ref : John C Hull, Options, Futures and Other Derivatives

Problem

We back test a VAR model with 1000 days of data. The VAR
confidence level is 99%. 17 exceptions are observed. Should
the model be rejected at 5% significance level?
Solution
The probability of the VAR being exceeded on a given day
= 1 - .99 = .01
The probability of the VAR being exceeded on 17 days or
more
=1 Binomdist (16, 1000, .01, True) = 2.64%
2.64% < 5%
So the model should be rejected.
Ref : John C Hull, Options, Futures and Other Derivatives
 Problem
A $10 million one year loan has a 1.25% probability of
default. If there is no default, profit of $ 0.2 million will be
made. If there is a default, the recovery can be anything
from 0 to the full loan value. Calculate the 99% VAR and
conditional VAR.
Solution
Default zone = 1.25% starting from 98.75% going up to
100%.
Loss at 99% point =[ .25/1.25] X 10 = $ 2 million.
So the 99% VAR is $ 2million.
Expected shortfall = {2 + 10]/2 = $ 6 million

60
Stress Testing

61
Introduction

Stress testing involves analysing the effects of

exceptional events in the market on a portfolio's
value.
These events may be exceptional, but they are also
plausible.
And their impact can be severe.
Historical scenarios or hypothetical scenarios can be
used.

62
Two approaches to Stress testing

Single-factor stress testing (sensitivity testing)

involves applying a shift in a specific risk factor to a
portfolio in order to assess the sensitivity of the
portfolio to changes in that risk factor.
Multiple-factor stress testing (scenario analysis)
involves applying simultaneous moves in multiple risk
factors to a portfolio to reflect a risk scenario or event
that looks plausible in the near future.

63
Extreme Value Theory
EVT is a branch of statistics dealing with the extreme deviations
from the mean of statistical distributions.
The key aspect of EVT is the extreme value theorem.
According to EVT, given certain conditions, the distribution of
extreme returns in large samples converges to a particular
known form, regardless of the initial or parent distribution of the
returns.
This distribution is characterized by three parameters location,
scale and shape (tail).
The tail parameter is the most important as it gives an
indication of the heaviness (or fatness) of the tails of the
distribution.
The EVT approach is very useful because the distributions from
which return observations are drawn are very often unknown.
EVT does not make strong assumptions about the shape of this
unknown distribution.
64
Gaussian Copulas

Consider variables, V1 and V2 that are not normally

distributed.
Map the two variables on to a normal distribution.
Apply correlation
Create bivariate normal distribution.

65
Illustration
Consider 2 variables that have a uniform distribution.
Using Gaussian copula, and assuming a copula
correlation of 0.3, define a correlation structure.

0.25 0.50 0.75

0.25
0.50
0.75

66
 0.25 0.50 0.75
0.25 -.675, -.675 -.675, 0 -.675, +.675
0.50 0, -.675 0, 0 0, +.
675
0.75 +.675, +.675, 0 +.675, .+
-.675 675

0.25 0.50 0.75

0.25 .095 .1633 .2157
0.50 .1633 .2985 .4134
0.75 .2157 .4134 .5953

67
Illustration
x percentil Z perce Z
e ntile
0. 5.00 -1.65 2.00 -2.06
1
0. 20.00 -.84 8.00 -1.41
2
0. 38.75 -.29 18.00 -.92
3
0. 55.00 .13 32.00 -.47
4
0. 68.75 .49 50.00 0
5
0. 80.00 .84 68.00 .47
6
0. 88.75 1.21 82.00 .92
7
0. 95.00 1.65 92.00 1.41
8 Correlation coefficient = 0.5

0. 98.75 2.24 98.00 2.06

9
68
 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
0.1 .006 .017 .028 .037 .044 .048 .049 .050 .050
0.2 .013 .043 .081 .120 .156 .181 .193 .198 .200
0.3 .017 .061 .124 .197 .273 .331 .364 .381 .387
0.4 .019 .071 .149 .248 .358 .449 .505 .535 .548
0.5 .019 .076 .164 .281 .417 .537 .616 .663 .683
0.6 .020 .078 .173 .301 .456 .600 .701 .763 .793
0.7 .020 .079 .177 .312 .481 .642 .760 .837 .877
0.8 .020 .080 .179 .318 .494 .667 .798 .887 .936
0.9 .020 .080 .180 .320 .499 .678 .816 .913 .970

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VAR Cash flow mapping

Problem
Consider a long position in a $1 million Treasury bond.
Maturity : 0.8 years
Coupon : 10% payable semiannually
Annualized yield & volatility
3 Month 6 Month 1 Year
Annualised yield 5.50 6.00 7.00
Volatility 0.06 0.10 0.20
Correlations between daily returns
3 Month 6 Month 1 Year
3 month 1.0 0.9 0.6
6 month 0.9 1.0 0.7
1 year 0.6 0.7 1.0

Explain how mapping can be done while calculating VaR.

Ref : John C Hull, Options, Futures and Other Derivatives

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Solution

The current position involves the following:

Cash flow of $50,000 in .3 years
Cash flow of $1,050,000 in .8 years
So the position can be considered a combination of
two zero coupon bonds, maturity 0.3, 0.8 years.
Let us write the position as equivalent to a
combination of standard 3 month, 6 month and 1
year bonds.
3 years = (.3) (12) = 3.6 months.
3 month interest rate = 5.50%
6 month interest rate = 6.00%
Effective interest rate for 3.6 months zero coupon bond
= 5.50 + (.6/3)(.5) = 5.6% = .056
mathewdo [printed: ____] [saved: May 31, 2007 6:24 PM] P:\WIP\310507\AV Vedpuriswar_Becoming a manager_310507_1408_v1.1.ppt

50,000
Present value = (1.056).3= 49,189
.6
Volatility = .06 =(.04.068%.
)
3
Let us allocate to a 3 month bond and 1 - to a 6
month bond.
Then we can write: 2 = 12 + 22 + 2 12

Here = .068 1 = .06 2 = .10 = .90

or .0682 = 2 (.06)2+ (1-)2(.10)2 + 2 (.9)() (1-)(.06)
(.10)
or .0682 = 2 (.06)2 + (1-)2 (.10)2 + 2(.9) ()(1-)(.06)
(.10)
Putting = .7603,
LHS = .00462, RHS = .00208 + .00057 + .001968 =.
00462
So we can write the position as equivalent to
Now consider $1,050,000 received after 0.8 years.
mathewdo [printed: ____] [saved: May 31, 2007 6:24 PM] P:\WIP\310507\AV Vedpuriswar_Becoming a manager_310507_1408_v1.1.ppt

It can be considered a combination of 6 month and 12

month positions.
3.6
Interpolating the interest rate we .06get:
(.01) =
6
.066 1,050,000
(1.066).8
Present value of cash flows = = $997,662
Volatility = [.1 + (3.6/6)(0.1) ] = 0.16
If is the position in the 6 month bond and (1-) in
the 12 month bond, 2 = 2 12 + (1-)2 22 + 2 (1-
) 12

Or (.16)2 = 2 (.1)2 + (1-)2 (.2)2 + 2 (.7) () (1-)

(.1)(.2)
LHS =.0256 Put =.320337; RHS =.001026 + .
01848 + .006096 .0256
So the position is equivalent to
 We can now write the portfolio in terms of 3 month, 6 month, 12
mathewdo [printed: ____] [saved: May 31, 2007 6:24 PM] P:\WIP\310507\AV Vedpuriswar_Becoming a manager_310507_1408_v1.1.ppt

month zero coupon bonds.

$50,000 $1,050,000 Total
t = .3 t = .8
3 month bond 37,397 -- 37, 397
6 month bond 11,791 319,589 331,380
12 month bond -- 678,074 678,074
Let 1, 2, 3 be the volatilities of the 3 month, 6 months, 12
mathewdo [printed: ____] [saved: May 31, 2007 6:24 PM] P:\WIP\310507\AV Vedpuriswar_Becoming a manager_310507_1408_v1.1.ppt

months bonds and 12, 13, 23 be the respective correlations.

2 = 12 + 22 + 32 + 21212 + 22323 + 21313

= [(37,397)2 (.06)2 + (331,380)2 (.10)2 + (678,074)2
(.20)2
+ (2) (37,397) (331,380) (.06) (.10) (.90)
+ (2) (331,380) (678,074) (.10) (.20) (.70)
+ (2) (37,397) (678,074) (.06) (.20) (.60)] x 10-4
= 2,628,536
= = $1621.3
10 day 99% VAR
= 1621.3 x 10 x 2.33
= $11,946