Jorion 1996
Jorion 1996
Jorion 1996
Philippe Jorion
The recent derivatives disasters have focused the attention of the finance industry on
the need to control financial risks better. This search has led to a uniform measure of
risk called value at risk (VAR), which is the expected worst loss over a given horizon
at a given confidence level. V A R numbers, however, are themselves affected by
sampling variation, or "estimation risk"--thus, the risk in value at risk itself.
Nevertheless, given these limitations, VAR is an indispensable tool to control
financial risks. This article lays out the statistical methodology for analyzing
estimation error in VAR and shows how to improve the accuracy of VAR estimates.
he need to improve control of financial risks In addition to financial reporting, VAR can be
T has led to a u n i f o r m measure of risk called
value at risk (VAR), which the private sector is
used for a variety of other purposes, such as setting
position limits for traders, measuring returns on a
increasingly adopting as a first line of defense risk-adjusted basis, and m o d e l evaluation. Institu-
against financial risks. Regulators and central tional investors are also embracing VAR as a dy-
banks also p r o v i d e d the impetus b e h i n d VAR. namic m e t h o d for controlling their exposure to risk
The Basle Committee on Banking Supervision factors, especially w h e n m a n y outside f u n d man-
a n n o u n c e d in April 1995 that capital adequacy agers are involved. Nonfinancial corporations, es-
requirements for commercial banks are to be pecially those involved with derivatives, are also
based on VAR. 1 In December 1995, the Securities considering risk-management systems centered
and Exchange Commission issued a proposal that a r o u n d VAR. VAR provides a consistent measure
requires publicly traded U.S. corporations to dis- of the effect of hedging on total risk, which is a
close information about derivatives activity, with significant i m p r o v e m e n t u p o n traditional h e d g i n g
a VAR measure as one ot! three possible m e t h o d s p r o g r a m s that typically focus only on individual
for making such disclosures. Thus, the unmistak- transactions. N o d o u b t these desirable features ex-
able trend is t o w a r d m o r e - t r a n s p a r e n t financial plain the wholesale trend t o w a r d VAR.
risk reporting based on VAR measures. Current implementations of VAR, however,
VAR summarizes the worst'expected loss over have not recognized the fact that VAR measures are
a target horizon within a given confidence interval. only estimates of risk. VAR should be considered
VAR s u m m a r i z e s in a single n u m b e r the global a first-order approximation to possible losses from
exposure to market risks and the probability of adverse financial risk. Although VAR is a vast im-
adverse m o v e s in financial variables. It measures p r o v e m e n t over no measure at all, VAR n u m b e r s
risk using the same units as the b o t t o m l i n e - - cannot be taken at face value. A VAR figure com-
dollars. Bankers Trust, for example, revealed in its bines existing positions with estimates of risk (in-
cluding correlations) over the target horizon. If
1994 annual report that its daily VAR was an aver-
these estimates are based on historical data, they
age of $35 million at the 99 percent confidence level
inevitably will be affected b y "estimation risk";
over one day; this n u m b e r can be readily c o m p a r e d
thus, value at risk also entails risk. 2
with its annual profit of $615 million or total equity
Recognizing the existence of estimation risk
of $4.7 billion. On the basis of such data, sharehold-
has several important consequences. For instance,
ers and managers can decide w h e t h e r they feel
users might w a n t to set the confidence level, usual-
comfortable with a level of risk. If the answer is no,
ly set arbitrarily, to a value that will minimize the
the process that led to the c o m p u t a t i o n of VAR can
error in VAR. Or, the statistical m e t h o d o l o g y might
be used to decide w h e r e to trim risk.
be g u i d e d b y the n e e d to minimize estimation error.
In addition, VAR should be reported with con-
fidence intervals. For instance, a b a n k m i g h t an-
Philippe Jorion is a professor of finance at the Graduate nounce that its VAR over the next day is $35 million
Schoolof Management at the University of California with a 95 percent confidence interval of $32 million
at Irvine. to $38 million. A tight interval indicates relative con-
20
VAR=$15million ~
5% of Occurrences
15
10
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Z
0
<-25 -20 -15 -10 -5 0 5 10 15 20 25
J.P. Morgan Daily Revenue ($ millions)
l-c= J f(w)dw
Sigma-Based VAR
R*
Generally, this m e t h o d applies to any proba-
bility function besides the normal, a convenient
= Stir)dr attribute because m a n y financial variables have
fatter tails (i.e., m o r e extreme observations) than
the n o r m a l distribution. Most notably, the stock
(5) m a r k e t crash of October 1987 was a 20 standard
deviation e v e n t - - o n e that u n d e r a n o r m a l distribu-
tion should n e v e r have h a p p e n e d . This behavior is
To report VAR at the 95 percent confidence level,
particularly w o r r i s o m e because VAR attempts to
for example, the 5 percent left-tailed deviate from
describe tail behavior precisely.
a standard n o r m a l distribution can be f o u n d from
One possible explanation is that volatility
standard n o r m a l tables as 1.645. Once 0~ is identi-
changes t h r o u g h time, increasing in times of great-
fied, VAR can be recovered as
er than n o r m a l turbulence. A stationary m o d e l
VAR= W0 x c~a,f~. (6) might then erroneously view large observations as
outliers w h e n they are really d r a w n from a distri-
The key result is that VAR is associated with the b u t i o n with temporarily greater dispersion. In-
standard deviation only. deed, the recent literature on time variation in
For instance, for the J.P. M o r g a n example from second m o m e n t s provides o v e r w h e l m i n g evidence
Figure 1, the standard deviation of the distribution that variances on a variety of financial assets do
is $9.2 million. Therefore, the normal-distribution change over time. 3
VAR is Even controlling for time variation, however,
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NOTES
1. The Basle Committee consists of central bankers from a risk can also capture structural changes as long as the
group of 10 countries. This committee sets minimum changes do not occur too abruptly.
standards for capital requirements in member countries. 4. For instance, Bankers Trust uses a 99 percent level of confi-
2. In addition, for complex portfolios involving positions in dence; Chemical Bank and Chase Manhattan, a 97.5 percent
options that are difficult to price, VAR is also affected by level; Citibank, a 95.4 percent level; and BankAmerica and
"model risk," which results from differences in valuations J.P. Morgan, a 95 percent level.
that can be traced to different option valuation models.
5. These simulations assumed that the underlying distribution
Another conceptual problem is that, especially over long
was known. If the distribution is truly irregular because of,
horizons, VAR does not account for changing positions.
Sound risk-management practices typically reduce the size for example, heavy optionality in the portfolio, nonparamet-
of positions in response to losses or increasing volatility, ric methods such as kernel estimation can be used to provide
which decreases the worst loss relative to a static VAR estimates of the quantile and associated standard errors.
measure. For further analysis of limitations of VAR methods, These methods lead to improved precision by smoothing the
see Jorion (1996). distribution. See, for example, Sheather and Marron (1990).
3. For a review, see, for instance, Bollerslev, Chou, and Kroner 6. For a description of the Orange County disaster, see Jorion
(1992). Time-series models that allow for time variation in (1995).
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Journal of Econometrics, vol. 52, no. 1 (April/May):5-59. ber):73-84.
Jorion, Philippe. 1995. Big Bets Gone Bad: Derivatives and Sheather, S., and J. Marron. 1990. "Kernel Quantile Estimators."
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. 1996. Value at Risk: The New Benchmark for Controlling
Market Risk. Chicago: Irwin.