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Chapter 2 Risk Management

Chapter 2 of the document focuses on risk management, detailing formulas for calculating portfolio variance, standard deviation, and value at risk (VAR). It explains how to convert standard deviation to monetary amounts and provides methods for estimating maximum loss over one or multiple days at a specified confidence level. The chapter assumes normal distribution of returns and independence of daily changes for multi-day calculations.

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12 views3 pages

Chapter 2 Risk Management

Chapter 2 of the document focuses on risk management, detailing formulas for calculating portfolio variance, standard deviation, and value at risk (VAR). It explains how to convert standard deviation to monetary amounts and provides methods for estimating maximum loss over one or multiple days at a specified confidence level. The chapter assumes normal distribution of returns and independence of daily changes for multi-day calculations.

Uploaded by

sachinpremvp
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd

Chapter 2 Risk Management

1. Variance of Portfolio’s Daily Change:


2 2
V =σ 1 +σ 2 +2 × ρ × σ 1 × σ 2

 σ 1: Standard deviation of the first asset’s daily change (in amount or percentage)

 σ 2: Standard deviation of the second asset’s daily change (in amount or


percentage)

 ρ : Correlation coefficient between the two assets’ returns

2. Portfolio Standard Deviation (Daily):

σ =√ V
 V : Variance of the portfolio’s daily change (calculated above)

 σ : Standard deviation of the portfolio’s daily change (in amount or percentage)

3. Portfolio Variance in Percentage Terms:


2
σ =¿
 w 1 , w 2: Weights of the first and second assets in the portfolio (as decimal fractions)

 σ 1 , σ 2 : Standard deviations of the individual assets (percentage terms)

 ρ : Correlation coefficient between the asset returns

4. Portfolio Standard Deviation (Percentage):

σ =√ σ 2

σ : Portfolio variance in percentage terms


2

 σ : Portfolio standard deviation in percentage terms

5. Conversion of Standard Deviation to Monetary Amount:


σ amount=σ percentage × Total Portfolio Value

 σ percentage: Standard deviation in percentage form


Chapter 2 Risk Management
 Total Portfolio Value : Total value of the portfolio in monetary terms

 σ amount: Standard deviation expressed in monetary amount

6. Standard Deviation for Multi-day Period (Assuming Independent Daily


Changes):

σ n -days=σ 1-day × √ n

 σ n -days: Standard deviation over n trading days

 σ 1-day: Standard deviation for one trading day

 n: Number of trading days (time horizon)

7. Value at Risk (VAR):


VAR=Z ×σ n-days

 Z : Z-score corresponding to selected confidence level (e.g., 2.33 for 99%)

 σ n -days: Standard deviation over the time horizon n days

8. Volatility in Monetary Terms (Example Calculation):


Volatility=Standard Deviation (%) ×Investment Value

 Standard Deviation (%): Daily price volatility expressed as percentage

 Investment Value: Monetary value of the investment

 Volatility: Monetary value of expected price variation

9. Z Score:
Z=Number of standard deviations away from mean

 Z: Quantifies the confidence level in standard deviation units

 Used to scale standard deviation to estimate maximum expected loss at given


confidence
Chapter 2 Risk Management
10. Maximum Loss over 1 Day (at 99% Confidence):
Maximum Loss1 -day =Volatility × Z

 Volatility: Monetary standard deviation of asset or portfolio for 1 day

 Z : Z-score for 99% confidence (2.33)

11. Maximum Loss over n Days (at 99% Confidence):

Maximum Loss n-days =√ n× Maximum Loss1 -day

 n: Number of trading days

 Maximum Loss 1 -day : Loss calculated for one day at desired confidence

Note: All formulas assume normal distribution of returns and independence of daily
returns for multi-day calculations.

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