11

RISK MANAGEMENT

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 RISK MANAGEMENT: VAR 11.2
Risk Management

Numerical Theoretical

Value at risk (VAR) Refer Theory Book

CONCEPT: VALUE AT RISK (VAR)

• VAR Measures the amount of potential loss that could happen in an
investment or portfolio over a given time period with given confidence
Level.
• Interpretation:
Suppose, VAR for 10 days with 95% confidence Level is  10,000.
For investment of  2,00,000

It means if someone invests  2,00,000 then he/she can make loss

max up to  10,000 in 10 days while there is 5% possibility that loss
may exceed  10,000. In other words, there is 95% possibility that
loss will be Lesser than or equal to  10,000.

• Now we must have knowledge of:

(i) Standard deviation (SD) and
(ii) Normal distribution table to understand the calculation of VAR.

• For standard deviation  Refer portfolio management

For normal distribution table  Refer Derivative (unit – II: option)

• Calculation:
VAR = [SD in Value () x Z score]
where,
 SD in value () = Investment x SD (%)
 SD of x Days = SD of Daily change x √x days
 To Calculate VAR for x days, use SD in value for x days.

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 11.3 AFM | SFM CLASS NOTES

 Z score [i.e., Z value of Normal dist. table] = No. of SD from

mean.
To Calculate Z value at given confidence Level we have to use Normal
distribution table (Any one of available for tables)

For some examples, we can calculate Z value at different confidence

level as follows:

Z =?

1,90,000 2,00,000

Prob 0.01 Prob 0.99

(i) At 99% C.L.
0.49 0.50

Prob 0.02 Prob 0.98

(ii) At 98% C.L.
0.48 0.50

(iii) and so on……

 Use of different tables to calculate Z value.

99% CL 98% CL
(A) Standard Normal dist. table.
Find that Z value where prob is 0.49 0.48

(B) One Tail table:

Find that Z value where prob is 0.01 0.02

(C) Two Tail table:

Find that Z value where prob is 0.02 0.04

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 RISK MANAGEMENT: VAR 11.4

(d) Cumulative standard N. Table:

Find that Z value where prob is [+ve Table] 0.99 0.98
[-ve Table] 0.01 0.02

(A) Standard Normal Distribution Table

This table provides probability of area “0 to Z”

This table provides

Prob of this area.

-∞ 0 Z +∞ -∞ Z 0 +∞
For +ve Z For -ve Z

(B) One Tail Normal Distribution Table

One tail table provides probability of area “Z to ∞” or, “Z to - ∞”

This table provides

Prob of this area.

-∞ 0 Z +∞ -∞ Z 0 +∞
For +ve Z For -ve Z

(C) Two Tail Normal Distribution Table

-∞ 0 Z +∞ -∞ Z 0 +∞
For +ve Z For -ve Z

This table provides Prob of this area. This table provides Prob of this area.
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 11.5 AFM | SFM CLASS NOTES

(D) Cumulative Standard Normal Distribution Table

This table provides probability of area “- ∞ to Z”

Z =?

-∞ 0 Z +∞ -∞ Z 0 +∞
For +ve Z For -ve Z

This table provides Prob of this area. This table provides Prob of this area.

QUESTION – 1A Risk Management

SD of daily change in (%) = 2%
SD of daily change in () = 100 lakh × 2% = 2 lakh
SD of 10 days change in () = 2 lakh × √10 = 6.3246 lakh

Requirement:
(i) Maximum loss of 1 day at 99% confidence [ i.e., 1 day 99% VAR]
= SD of daily change in () × Z score
= 2 × 2.33 = 4.66 lakh

(ii) Maximum loss of 10 days at 99% confidence [ i.e., 10 days 99%

VAR]
= SD of 10 days change in () × Z score
= 6.3246 × 2.33 = 14.7363 lakh

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 RISK MANAGEMENT: VAR 11.6
Question – 1B
Portfolio Composition
Stock Investment Weight SD (Daily Change)
XYZ 2,00,00,000 2/4 = 0.50 1%

ABC 2,00,00,000 2/4 = 0.50 1%

4,00,00,000 1 -

Correlation (XYZ, ABC) = 0.30

We know,

σport =√(σx Wx )2 + (σA WA )2 + 2(σx Wx )(σA WA )rx,A

=√(1 × 0.50)2 + (1 × 0.50)2 + 2 × 1 × 0.50 × 1 × 0.50 × 0.30

= 0.8062%

SD of Port in () =  400 Lakh x 0.8062%

=  3.2248 Lakh (Daily Change)

SD of Portfolio of 10 days change in ()

= 3.2248 x √10 =  10.1977 Lakh

Z score for 99% confidence level = 2.33 (i.e., Significant Level)

Hence, 10 days 99% VAR

= SD of Portfolio of 10 days change x Z
= 10.1977 x 2.33 =  23.7606 Lakh

Second alternative:
To calculate SD of portfolio in  (As used by ICAI)
SD of portfolio in () = √SDx 2 + SDA 2 + 2 SDx SDA rx,A

SDx = 200,00,000 × 1% =  2 lakh

SDA = 200,00,000 × 1% =  2 lakh
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 11.7 AFM | SFM CLASS NOTES

Second alternative:

SD of portfolio in () = √(2)2 + (2)2 + 2 × 2 × .30

= √10.4 = 3.2249 lakh (as calculated in
first alternative)

QUESTION – 1C
For calculating probability of financial difficulty, we shall calculate the
area under Normal Curve corresponding to the Z Score obtained from
the following equation (how many SD is away from Mean Value of financial
difficulty):
X−μ −1 crore − 2 crore
Z = = = -1.875 say 1.875
σ 1.60 crore

Corresponding area from Z score Table by using interpolation shall be

found as follows:
Z Score Area under Normal Curve
1.87 0.4693
1.88 0.4699
0.01 0.0006

0.0006
The corresponding value of 0.005 Z score = 0.005 × = 0.0003
0.01

Thus, the value of 1.875 shall be = 0.4693 + 0.0003

The probability of return between -1cr and 2cr (i.e., -1≤x≤2) = 0.4696
The probability of return below -1 cr = 0.50 – 0.4696 = 0.0304
Thus, the probability the company shall be in financial difficulty is
3.04%.

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 RISK MANAGEMENT: VAR 11.8

QUESTION – 1D Risk Management

Balance in Bank 11,00,00,000

Add: FD maturity 63,42,560
Total 11,63,42,560
Less: Minimum Balance - 1000
Free balance 11,63,41,560

Calculation of SD
𝟐 𝟐
𝐑𝐗 𝐑 𝐗 𝐑 𝐗 - 𝐑 𝐗 (𝐑 𝐗 − 𝐑 𝐗 ) 𝐑𝐘 𝐑𝐘 𝐑 𝐘 - 𝐑 𝐘 (𝐑 𝐘 − 𝐑 𝐘 )
6 8 -2 4 4 8 -4 16
7 8 -1 1 6 8 -2 4
8 8 0 0 8 8 0 0
9 8 -1 1 10 8 2 4
10 8 2 4 12 8 4 16

𝐑 𝐗 = (6 × .10) + (7 × .25) + (8 × .30) + (9 × .25) + (10 × .10)

= 8%

𝐑 𝐘 = (4 × .10) + (6 × .20) + (8 × .40) + (10 × .20) + (12 × .10)

= 8%

𝛔𝐗 = √(4 × .10) + (1 × .25) + (0 × .30) + (1 × .25) + (4 × .10)

= 1.14%

𝛔𝐘 = √(16 × .10) + (4 × .20) + (0 × .40) + (4 × .20) + (16 × .10)

= 2.19%

Note:
As question is silent regarding the period of return which are given in
table, we can assume it as daily return or weekly return.
ICAI assumed it as daily return.

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 11.9 AFM | SFM CLASS NOTES

4 days SD (X) = 1.14 × √4 = 2.28% (i.e., 0.0228)

4 days SD (Y) = 2.19 × √4 = 4.38% (i.e., 0.0438)

(i) VAR(X) =Z×𝜎

or, 11,63,41,560 = 2.33 × (x × .0228)
∴ x = 2,19,00,00,000

(ii) VAR(Y) =Z×𝜎

or, 11,63,41,560 = 2.33 × (x × .0438)
∴ x = 1,14,00,00,000

Advice: As investment amount is higher in Stock-X, it is advisable

to invest in Stock-X

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 RISK MANAGEMENT: VAR 11.10

Important Notes:

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