Culp, Miller & Neves - Value at Risk - Uses and Abuses Flashcards
What is VaR?
$ loss that is expected to occur no more than 5% of the time over the defined risk horizon.
Features of VaR that account for its widespread popularity
- its consistent measurement of financial risk. By expressing risk using a “possible $ loss”, VaR makes possible direct comparisons of risk across different business lines and distinct financial products.
- It is probability based. VaR can be interpreted as forward-looking approximations of potential market risk.
- Its reliance on a common time horizon. 5% => they stand to lose more than $X on no more than 5 days out of 100.
What are the two steps of creating a VaR distribution for a given risk horizon?
Step 1: generate the price or return distributions for each individual security or asset in the portfolio.
Step 2: Aggregate the component assets into a portfolio distribution using appropriate measures of correlation.
Why is VaR relatively realistic for derivative dealers?
An important assumption in all VaR calculations is that the portfolio does not change over the risk horizon. This assumption of no turnover was not a major issue for derivative dealers when they focused on one- or two-day risk horizons.
Uses of VaR
Risk Reporting — Its simplicity allowed for quick and efficient risk reporting to senior management.
Risk Control — It also proved useful as a means to monitor and set risk levels by market, by trading group or by counterparty.
Risk Management — VaR provided useful information for hedging risks and evaluating any particular transaction’s effect on portfolio risk.
Three alternatives to VaR
Cash Flow Risk — Simulating future cash requirements can be a useful tool for firms concerned with cash flow variability, either for setting prudent debt levels or establishing contingent funding arrangements.
Risk Based Capital - Establish risk based capital measures and to evaluate the opportunities in relation to those measures. This is more difficult than implementing VaR because it is not clear what the appropriate cost of capital might be for different risks.
Shortfall Risk - allow a risk manager to define a specific target value below which the organization’s assets must never fall and produce estimates of risk accordingly.
Two specific examples of this:
- Below Target Probability (BTP), ithe probability of having a shortfall relative to the specified target.
- Below Target Risk, measures the average value of outcomes below the target.
The advantages of BTR over VAR are that:
- BTR penalizes large shortfalls more so than small ones.
- BTR is based on a real target, but the target level in VaR (e.g. 99%) is an arbitrary level.
The authors note that VaR is not very useful for speculative hedging or for entities that knowingly take risks. Why?
VaR only focuses on the potential losses without any consideration given to the potential gains. It is therefore not a useful measure for balancing the risk-reward trade-offs.
Indentify and briefly discuss the investment and situation the led to one of the four disasters. (include how VaR measures may or may not have helped)
Metallgesellschaft: its subsidiary MGRM had entered into fixed price contracts with it’s customer for 10 years. They hedge their risk to the general price of oil by buying short term future prices. When oil price dropped, they gained on the fixed price contracts, but lost on futuers, which must be maked to market. This created a cash flow drain on its parent, who forced MGRM to close out its position and realize the loss.
VaR would not have helped because they knew the basic risk they were taking. VaR is a total risk measure, not a cash flow mearsure.
You are considering using Conditional Tail Expectation (CTE), Expected Policyholder Deficit (EPD) and Below Target Risk (BTR). Describe how these three measures relate to each other, identifying specific differences between them.
CTE: the average of all loss scenario that are worse than some specific percentile of the loss distribution.
EPD:
- similar to CTE in that it calculate the average of value exceed a certain threshold
- Three difference to CTE:
- threshold is where liability exceeds assets rather than a percentile
- includes only the shortfall between liability and asset
- treats non shortfall scenarios as having a zero shortfall. => CTE is conditional mean value, EPD is unconditional.
BTR:
- more general version of EPD that can measure the risk relative to any threshold
- like both CTE and EPD, BTR reflects the size of loss, not just prob. of loss.
Culp, Miller and Neves cite four well-known derivatives disasters involving P&G,
Orange County, Barings and Metallgesellschaft.
Briefly describe what happend, and in each case why the use of VaR would have been unlikely to prevent these disasters?
- P&G’s treasury department lost hundreds of millions of dollars using fixed for floating interest rate swaps that contained an embedded bet on the movement of the term structure.
- VaR was never intended to be used at the transaction level and it is unlikely that a firm focused on cash flow risk management would have had the monitoring systems in place to approve swap transactions based on the VaR.
- Orange County’s treasurer lost $1.5 billion through the use of leveraged inverse floating rate bonds (and other similar products) when rates rose more than expected.
- It is argued that the Orange County treasurer was intentionally taking a bet on interest rates in order to improve his portfolio returns. Since VaR focuses only on the downside without any mechanism to assess the risk in relation to the potential gains, this risk measure would have been unlikely to motivate any change in strategy.
- Barings lost over a billion dollars when a “rogue” trader used put options and future
options to bet on the Nikkei index, seemingly without approval and without reporting
the transactions or their status to his supervisors.- Leeson himself was responsible for monitoring his portfolio and it is probably safe to assume that he would not have reported his VaR to his superiors.
- Metallgesellschaft lost over a billion dollars when oil and gas prices fell and the shortterm futures contracts being used to hedge long-term fixed price contracts lost money and could not be rolled over.
- MGRM was in the business of taking these risks and appeared to be doing it knowingly. It seems unlikely that whatever additional information contained in the VaR would have altered their strategy.
