Var as a Market Risk Measure

Topics: Risk, Variance, Value at risk Pages: 17 (4710 words) Published: June 25, 2013
PAGE |I

BACHELOR THESIS

Is VaR a useful Market Risk Measure?

Author: Andrea Notario Peñuelas

Tutor: Rafael Jaime Hernández Barros

Bachelor: Finance&Accounting

Madrid, July 2012

P A G E | II

Abstract
The recent financial crisis has shown that VAR has not been successful on quantifying market risk. Quantifying market risk is important because it allows regulators to assess the solvency of an entity and allows risk managers to manage efficiently the entities capital (Fallon 1996 , p.1) as well as to ``measure the profitability of different business units´´(Fallon 1996 ,p.2). The thesis has a financial risk management dimension, specially focused on portfolio risk management. A study on VAR will be done, beginning with a explanation of the different traditional methods that had been created, continuing with a study of the alternatives methods that have been developed (EVT, Copula-GARCH, etc.), and ending with a critique of VaR as a market risk measure and GARCH method.

Keywords: VAR, Market risk, alternative methods, traditional methods, Portfolio Risk Management.

P A G E | III

Contents
1.INTRODUCTION ............................................................................................................. 5 2.BACKGROUND ............................................................................................................... 7 2.1 Volatility and Correlation ............................................................................... 7 2.1.1 Introduction ……………………………………………………...........7 2.1.2 Correlation …………………………………………………….............8 2.1.3 Volatility ........................................................................................ 8 2.2 Properties of asset's return........................................................................... 3.VAR AS A MARKET RISK MEASURE......................................................................... 3.1 Market risk .......................................................................................... 3.1.1 What is Market risk? ................................................................ 9 12 12 12

3.1.2 Why do we need to measure market risk? ................................... 12 3.2 VaR..................................................................................................... 3.2.1 Definition ............................................................................... 3.2.2 How VaR is calculated ............................................................. 4. TRADITIONAL METHODS .................................................................................... 4.1 Classification ....................................................................................... 4.2 Variance - covariance method (delta- normal) ......................................... 4.3 Historical Simulation ............................................................................ 4.4 Monte carlo Simulation ......................................................................... 4.5 Comparaison ....................................................................................... 13 13 14 15 16 17 18 19 20

P A G E | IV 5. ALTERNATIVE VAR METHODS ........................................................................... 5.1 Variance methods .................................................................................. 5.1.1 Introduction.............................................................................. 5.1.2 ARCH, GARCH and EWMA...................................................... 5.1.3 Assymetry GARCH Versions & GJR .......................................... 5.2 Extreme value methods ............................................................................ 5.2.1 Introduction .............................................................................. 5.2.2 Extreme Value methods description ........................................ 5.3 Copula GaRCH...
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