# IEOR E4602: Quantitative Risk Management

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1 IEOR E4602: Quantitative Risk Management Risk Measures Martin Haugh Department of Industrial Engineering and Operations Research Columbia University Reference: Chapter 8 of 2 nd ed. of MFE s Quantitative Risk Management.

2 Risk Measures Let M denote the space of random variables representing portfolio losses over some fixed time interval,. Assume that M is a convex cone so that If L 1, L 2 M then L 1 + L 2 M And λl 1 M for every λ > 0. A risk measure is a real-valued function, ϱ : M R, that satisfies certain desirable properties. ϱ(l) may be interpreted as the riskiness of a portfolio or the amount of capital that should be added to the portfolio so that it can be deemed acceptable Under this interpretation, portfolios with ϱ(l) < 0 are already acceptable In fact, if ϱ(l) < 0 then capital could even be withdrawn. 2 (Section 1)

3 Axioms of Coherent Risk Measures Translation Invariance For all L M and every constant a R, we have ϱ(l + a) = ϱ(l) + a. - necessary if earlier risk-capital interpretation is to make sense. Subadditivity: For all L 1, L 2 M we have ϱ(l 1 + L 2 ) ϱ(l 1 ) + ϱ(l 2 ) - reflects the idea that pooling risks helps to diversify a portfolio - the most debated of the risk axioms - allows for the decentralization of risk management. 3 (Section 1)

4 Axioms of Coherent Risk Measures Positive Homogeneity For all L M and every λ > 0 we have ϱ(λl) = λϱ(l). - also controversial: has been criticized for not penalizing concentration of risk - e.g. if λ > 0 very large, then perhaps we should require ϱ(λl) > λϱ(l) - but this would be inconsistent with subadditivity: ϱ(nl) = ϱ(l + + L) nϱ(l) (1) - positive homogeneity implies we must have equality in (1). Monotonicity For L 1, L 2 M such that L 1 L 2 almost surely, we have ϱ(l 1 ) ϱ(l 2 ) - clear that any risk measure should satisfy this axiom. 4 (Section 1)

5 Coherent Risk Measures Definition: A risk measure, ϱ, acting on the convex cone M is called coherent if it satisfies the translation invariance, subadditivity, positive homogeneity and monotonicity axioms. Otherwise it is incoherent. Coherent risk measures were introduced in and a large literature has developed since then. 5 (Section 1)

6 Convex Risk Measures Criticisms of subadditivity and positive homogeneity axioms led to the study of convex risk measures. A convex risk measure satisfies the same axioms as a coherent risk measure except that subadditivity and positive homogeneity axioms are replaced by the convexity axiom: Convexity Axiom For L 1, L 2 M and λ [0, 1] ϱ(λl 1 + (1 λ)l 2 ) λϱ(l 1 ) + (1 λ)ϱ(l 2 ) It is possible to find risk measures within the convex class that satisfy ϱ(λl) > λϱ(l) for λ > 1. 6 (Section 1)

7 Value-at-Risk Recall... Definition: Let α (0, 1) be some fixed confidence level. Then the VaR of the portfolio loss, L, at the confidence level, α, is given by VaR α := q α (L) = inf{x R : F L (x) α} where F L ( ) is the CDF of the random variable, L. Value-at-Risk is not a coherent risk measure since it fails to be subadditive! 7 (Section 1)

8 Example 1 Consider two IID assets, X and Y where X = ɛ + η where ɛ N(0, 1) and η = { 0, with prob , with prob.009. Consider a portfolio consisting of X and Y. Then VaR.99 (X + Y ) = 9.8 > VaR.99 (X) + VaR.99 (Y ) = = thereby demonstrating the non-subadditivity of VaR. 8 (Section 1)

9 Example 2: Defaultable Bonds Consider a portfolio of n = 100 defaultable corporate bonds Probability of default over next year identical for all bonds and equal to 2%. Default events of different bonds are independent. Current price of each bond is 100. If bond does not default then will pay 105 one year from now - otherwise there is no repayment. Therefore can define the loss on the i th bond, L i, as L i := 105Y i 5 where Y i = 1 if the bond defaults over the next year and Y i = 0 otherwise. By assumption also see that P(L i = 5) =.98 and P(L i = 100) = (Section 1)

10 Example 2: Defaultable Bonds Consider now the following two portfolios: A: A fully concentrated portfolio consisting of 100 units of bond 1. B: A completely diversified portfolio consisting of 1 unit of each of the 100 bonds. We want to compute the 95% VaR for each portfolio. Obtain VaR.95 (L A ) = 500, representing a gain(!) and VaR.95 (L B ) = 25. So according to VaR.95, portfolio B is riskier than portfolio A - absolute nonsense! Have shown that ( 100 ) 100 VaR.95 L i 100 VaR.95 (L 1 ) = VaR.95 (L i ) i=1 demonstrating again that VaR is not sub-additive. i=1 10 (Section 1)

11 Example 2: Defaultable Bonds Now let ϱ be any coherent risk measure depending only on the distribution of L. Then obtain (why?) ϱ ( 100 ) L i i=1 100 ϱ(l i ) = 100ϱ(L 1 ) i=1 - so ϱ would correctly classify portfolio A as being riskier than portfolio B. We now describe a situation where VaR is always sub-additive (Section 1)

12 Subadditivity of VaR for Elliptical Risk Factors Theorem Suppose that X E n (µ, Σ, ψ) and let M be the set of linearized portfolio losses of the form n M := {L : L = λ 0 + λ i X i, λ i R}. i=1 Then for any two losses L 1, L 2 M, and 0.5 α < 1, VaR α (L 1 + L 2 ) VaR α (L 1 ) + VaR α (L 2 ). 12 (Section 1)

13 Proof of Subadditivity of VaR for Elliptical Risk Factors Without (why?) loss of generality assume that λ 0 = 0. Recall if X E n (µ, Σ, ψ) then X = AY + µ where A R n k, µ R n and Y S k (ψ) is a spherical random vector. Any element L M can therefore be represented as L = λ T X = λ T AY + λ T µ λ T A Y 1 + λ T µ (2) - (2) follows from part 3 of Theorem 2 in Multivariate Distributions notes. Translation invariance and positive homogeneity of VaR imply VaR α (L) = λ T A VaR α (Y 1 ) + λ T µ. Suppose now that L 1 := λ T 1 X and L 2 := λ T 2 X. Triangle inequality implies (λ 1 + λ 2 ) T A λ T 1 A + λ T 2 A Since VaR α (Y 1 ) 0 for α.5 (why?), result follows from (2). 13 (Section 1)

14 Subadditivity of VaR Widely believed that if individual loss distributions under consideration are continuous and symmetric then VaR is sub-additive. This is not true(!) Counterexample may be found in Chapter 8 of MFE The loss distributions in the counterexample are smooth and symmetric but the copula is highly asymmetric. VaR can also fail to be sub-additive when the individual loss distributions have heavy tails. 14 (Section 1)

15 Expected Shortfall Recall... Definition: For a portfolio loss, L, satisfying E[ L ] < the expected shortfall (ES) at confidence level α (0, 1) is given by ES α := 1 1 α 1 α q u (F L ) du. Relationship between ES α and VaR α therefore given by ES α := 1 1 α 1 α VaR u (L) du (3) - clear that ES α (L) VaR α (L). When the CDF, F L, is continuous then a more well known representation given by ES α = E [L L VaR α ]. 15 (Section 1)

16 Expected Shortfall Theorem: Expected shortfall is a coherent risk measure. Proof: Translation invariance, positive homogeneity and monotonicity properties all follow from the representation of ES in (3) and the same properties for quantiles. Therefore only need to demonstrate subadditivity - this is proven in lecture notes. There are many other examples of risk measures that are coherent - e.g. risk measures based on generalized scenarios - e.g. spectral risk measures - of which expected shortfall is an example. 16 (Section 1)

17 Risk Aggregation Let L = (L 1,..., L n ) denote a vector of random variables - perhaps representing losses on different trading desks, portfolios or operating units within a firm. Sometimes need to aggregate these losses into a random variable, ψ(l), say. Common examples include: 1. The total loss so that ψ(l) = n i=1 L i. 2. The maximum loss where ψ(l) = max{l 1,..., L n }. 3. The excess-of-loss treaty so that ψ(l) = n i=1 (L i k i ) The stop-loss treaty in which case ψ(l) = ( n i=1 L i k) (Section 2)

18 Risk Aggregation Want to understand the risk of the aggregate loss function, ϱ(ψ(l)) - but first need the distribution of ψ(l). Often know only the distributions of the L i s - so have little or no information about the dependency or copula of the L i s. In this case can try to compute lower and upper bounds on ϱ(ψ(l)): ϱ min := inf{ϱ(ψ(l)) : L i F i, i = 1,..., n} ϱ max := sup{ϱ(ψ(l)) : L i F i, i = 1,..., n} where F i is the CDF of the loss, L i. Problems of this type are referred to as Frechet problems - solutions are available in some circumstances, e.g. attainable correlations. Have been studied in some detail when ψ(l) = n i=1 L i and ϱ( ) is the VaR function. 18 (Section 2)

19 Capital Allocation Total loss given by L = n i=1 L i. Suppose we have determined the risk, ϱ(l), of this loss. The capital allocation problem seeks a decomposition, AC 1,..., AC n, such that ϱ(l) = n AC i (4) i=1 - AC i is interpreted as the risk capital allocated to the i th loss, L i. This problem is important in the setting of performance evaluation where we want to compute a risk-adjusted return on capital (RAROC). e.g. We might set RAROC i = Expected Profit i / Risk Capital i - must determine risk capital of each L i in order to compute RAROC i. 19 (Section 3)

20 Capital Allocation More formally, let L(λ) := n i=1 λ il i be the loss associated with the portfolio consisting of λ i units of the loss, L i, for i = 1,..., n. Loss on actual portfolio under consideration then given by L(1). Let ϱ( ) be a risk measure on a space M that contains L(λ) for all λ Λ, an open set containing 1. Then the associated risk measure function, r ϱ : Λ R, is defined by We have the following definition... r ϱ (λ) = ϱ(l(λ)). 20 (Section 3)

21 Capital Allocation Principles Definition: Let r ϱ be a risk measure function on some set Λ R n \ 0 such that 1 Λ. Then a mapping, f rϱ : Λ R n, is called a per-unit capital allocation principle associated with r ϱ if, for all λ Λ, we have n i=1 λ i f rϱ i (λ) = r ϱ (λ). (5) We then interpret f rϱ i as the amount of capital allocated to one unit of L i when the overall portfolio loss is L(λ). The amount of capital allocated to a position of λ i L i is therefore λ i f rϱ i so by (5), the total risk capital is fully allocated. and 21 (Section 3)

22 The Euler Allocation Principle Definition: If r ϱ is a positive-homogeneous risk-measure function which is differentiable on the set Λ, then the per-unit Euler capital allocation principle associated with r ϱ is the mapping f rϱ : Λ R n : f rϱ i (λ) = r ϱ λ i (λ). The Euler allocation principle is a full allocation principle since a well-known property of any positive homogeneous and differentiable function, r( ) is that it satisfies n r r(λ) = λ i (λ). λ i i=1 The Euler allocation principle therefore gives us different risk allocations for different positive homogeneous risk measures. There are good economic reasons for employing the Euler principle when computing capital allocations. 22 (Section 3)

23 Value-at-Risk and Value-at-Risk Contributions Let r α VaR (λ) = VaR α(l(λ)) be our risk measure function. Then subject to technical conditions can be shown that f rα VaR i (λ) = r VaR α (λ) λ i = E [L i L(λ) = VaR α (L(λ))], for i = 1,..., n. (6) Capital allocation, AC i, for L i is then obtained by setting λ = 1 in (6). Will now use (6) and Monte-Carlo to estimate the VaR contributions from each security in a portfolio. - Monte-Carlo is a general approach that can be used for complex portfolios where (6) cannot be calculated analytically. 23 (Section 3)

24 An Application: Estimating Value-at-Risk Contributions Recall total portfolio loss is L = n i=1 L i. According to (6) with λ = 1 we know that AC i = E [L i L = VaR α (L)] (7) = VaR α(λ) λ i λ=1 = w i VaR α w i (8) for i = 1,..., n and where w i is the number of units of the i th security held in the portfolio. Question: How might we use Monte-Carlo to estimate the VaR contribution, AC i, of the i th asset? Solution: There are three approaches we might take: 24 (Section 3)

25 First Approach: Monte-Carlo and Finite Differences As AC i is a (mathematical) derivative we could estimate it numerically using a finite-difference estimator. Such an estimator based on (8) would take the form ÂC i := VaRi,+ α VaR i, α (9) 2δ i where VaR i,+ α (VaR i, α ) is the portfolio VaR when number of units of the i th security is increased (decreased) by δ i w i units. Each term in numerator of (9) can be estimated via Monte-Carlo - same set of random returns should be used to estimate each term. What value of δ i should we use? There is a bias-variance tradeoff but a value of δ i =.1 seems to work well. This estimator will not satisfy the additivity property so that n i ÂC i VaR α - but easy to re-scale estimated ÂC i s so that the property will be satisfied. 25 (Section 3)

26 Second Approach: Naive Monte-Carlo Another approach is to estimate (7) directly. Could do this by simulating N portfolio losses L (1),..., L (N) with L (j) = n i=1 L(j) i - L (j) i is the loss on the i th security in the j th simulation trial. Could then set (why?) AC i = L (m) i where m denotes the VaR α scenario, i.e. L (m) is the N (1 α) th largest of the N simulated portfolio losses. Question: Will this estimator satisfy the additivity property, i.e. will n i AC i = VaR α? Question: What is the problem with this approach? Will this problem disappear if we let N? 26 (Section 3)

27 A Third Approach: Kernel Smoothing Monte-Carlo An alternative approach that resolves the problem with the second approach is to take a weighted average of the losses in the i th security around the VaR α scenario. A convenient way to do this is via a kernel function. In particular, say K(x; h) := K ( x h ) is a kernel function if it is: 1. Symmetric about zero 2. Takes a maximum at x = 0 3. And is non-negative for all x. A simple choice is to take the triangle kernel so that ( K(x; h) := max 1 x ), 0. h 27 (Section 3)

28 A Third Approach: Kernel Smoothing Monte-Carlo The kernel estimate of AC i is then given by ( N ÂC ker j=1 K L (j) ˆ ) VaR α ; h L (j) i i := ( N j=1 K L (j) VaR ˆ ) (10) α ; h where VaR α := L (m) with m as defined above. One minor problem with (10) is that the additivity property doesn t hold. Can easily correct this by instead setting ( N ÂC ker i := VaR j=1 K L (j) ˆ ) VaR α ; h L (j) i α ( N j=1 K L (j) VaR ˆ ). (11) α ; h L (j) Must choose an appropriate value of smoothing parameter, h. Can be shown that an optimal choice is to set h = σ N 1/5 where σ = std(l), a quantity that we can easily estimate. 28 (Section 3)

29 When Losses Are Elliptically Distributed If L 1,..., L N have an elliptical distribution then it may be shown that AC i = E [L i ] + Cov (L, L i) Var (L) (VaR α (L) E [L]). (12) In numerical example below, we assume 10 security returns are elliptically distributed. In particular, losses satisfy (L 1,..., L n ) MN n (0, Σ). Other details include: 1. First eight securities were all positively correlated with one another. 2. Second-to-last security uncorrelated with all other securities. 3. Last security had a correlation of -0.2 with the remaining securities. 4. Long position held on each security. Estimated VaR α=.99 contributions of the securities displayed in figure below - last two securities have a negative contribution to total portfolio VaR - also note how inaccurate the naive Monte-Carlo estimator is - but kernel Monte-Carlo is very accurate! 29 (Section 3)

30 2 1.5 VaR α Contributions By Security Analytic Kernel Monte Carlo Naive Monte Carlo 1 Contribution Security 30 (Section 3)

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