The German and French Stock Markets Volatility as Observed from the VaR

Lens

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Abstract

This paper presents a complete analysis and implementation pilotus of the VaR estimates for the
French and German stock markets over the last three years. The mechanics of the 500-day
historical simulation approach are applied for both markets. Weighting recent observations more
heavily produced similar results compared to the simple approach. Using the volatility updating
to adjust for nonstationarity feature of both market indices together with the Extreme Value
Theory and Expected Shortfall yielded accurate 99th percentile risk measures all close to 2.41%
of the portfolio reference value.

Keywords: VaR, Historical Simulation Approach, EWMA, Volatility Updating, French and
German Stock Market, Extreme Value Theory, Expected Shortfall.

1. Introduction

Value at Risk, VaR, is the most commonly used risk metric approach among regulators and risk
managers because of its simplicity in providing a single number that describes the total risk in a
portfolio. It is the worse return over the next K days that the risk manager is sure up to p % will
not be exceeded, where p and N are determined by the analyst. Therefore the VaR is a quantile of
the return distribution.

Among the common approaches to measure the VaR we name the model-building and the
historical simulation approaches. The first approach referred to as variance-covariance
approach assumes a model for the joint distribution of changes in market variables and uses
historical data to estimate the model parameters. Daily returns on the investments are supposed
to be conditionally multivariate normal with a zero mean percentage change in each variable and
therefore the probability distribution for the change in the value of the portfolio is also normal. If
a portfolio involves nonlinear products the use of this approach becomes difficult and
approximations for the VaR calculation are necessary. The gains or losses on the component
parts of the portfolio are not always normally distributed. In such circumstances, the use of the
historical simulation approach is more appropriate; it efficiently translates the probability
distribution for the market variables (Hull and White (6)).

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The purpose of this paper is to measure the VaR for both the German and French Stock Markets
over the last three years using the historical simulation approach. More weights to recent data
are allocated in addition to incorporating volatility data into the VaR estimates as suggested by
Hull and White (6). Covering the Extreme Value Theory and Expected Shorfall measures for
both markets constitutes an added value for the paper which can be used as a simple and easy-to-
use reference guide for risk managers.

The rest of the paper proceeds as follow: in section 2 a quick review of the VaR is presented.
Section 3 is allocated for the description of the portfolio selection, methodology and the VaR
estimates with its standard error using the standard approach. Section 4 implements the EWMA
weighting schemes and compares it with the volatility-adjusted approach. Section 5 concludes
and discusses the findings through the comparison with the Extreme Value Theory and Expected
Shortfall.

2. Review of the VaR: The Historical Simulation Approach

Value at Risk became very popular as a risk management and regulatory instrument. It
determines the value of a portfolio that could decline over a given period of time with a given
probability as a result of changes in market variables. (Butler J. S. and Schachter B. (3)). The
holding period (N) and confidence level are the components typically used for a market risk VaR
calculation. Both components are discretionary, however, in practice, analysts set N equal to one
in the first instance because there is not enough data to estimate directly the behavior of market
variables over periods of time exceeding one day (Hull J. (4)). The assumption is

N-day VaR = 1-day VaR x (1)

This formula is true when the changes in the value of the portfolio on successive days have
independent identical normal distributions with mean zero. In other cases it is approximation.

The simple formula for the VaR is

VaR = 1 () (2)

Where

X is the confidence level,

is the standard deviation of the portfolio change over the time horizon, and
1 (.) is the inverse cumulative normal distribution.
Equation (2) shows that regardless of the holding period, VaR is proportional to .

A VaR estimate with one confidence level can be used to calculate a VaR level with another
confidence level. However, when the independence assumption is relaxed, equation (3) can be
used to move the one-day VaR to the N-Day VaR. If we define as the change in the value of
a portfolio on day i and the correlation between and 1 for all i, and suppose the

2
variance of is 2 for all i, then the correlation between and is and the variance
of =1 is:

2 + 2 1 + 2 2 2 + 2 3 3 + + 21 (3)

When a portfolio has a number of subportfolios, the marginal VaR with respect to the ith
subportfolio is the partial derivative of VaR with respect the size of the subportfolio. In other
words it is the sensitivity of VaR to the size xi of that subportfolio. It is

It is closely related to the beta of the capital asset pricing model and follows the same tendency.
The incremental VaR on the other side is the incremental effect on VaR of the ith subportfolio. It
defines the difference between VaR with and without the subportfolio (Jorion P. (8)).

According to Artzner P et al. (1) the VaR is not the best alternative to describe in a single
number the risk of a portfolio because it may lead traders to choose a riskier portfolio with the
same VaR as a less risky one. They suggested a measure known as C-VaR (or expected shortfall,
or conditional tail or tail loss) to overcome this problem. The C-VaR is the expected shortfall
loss during an N-day period conditional that an outcome in the p% tail of the distribution. The C-
VaR has more properties because it encourages diversification however it is more complicated to
implement and understand by managers and investors and more difficult to back-test.

In the historical simulation approach there are many steps to follow (Jorion P. (8)). Identifying
the market variables affecting the portfolio such as exchange rates, equity prices, interest rates,
etc. is essential. Data are then collected on movements in these market variables over the
selected N days. This allows N alternative scenarios for what can happen between today and
tomorrow (Hull J. (5)). If the first day is denoted Day 0, the second Day 1, and so on, scenario 1
would be where the percentage changes in the values of all variables are the same as they were
between Day 0 and Day 1. Scenario 2 would be likewise but following Day 1 and Day 2.

In this paper, we will implement the historical simulation approach to calculating VaR because
it has the advantage that historical data determine the joint probability distribution of the market
variables. Even if this approach does not allow volatility updating schemes to be used, we will
incorporate volatility in our calculation as suggested by Hull J. and A. White (6).

3. Portfolio Selection and Methodology

We will calculate the VaR for both the French and German stock markets through their stock
indices: the CAC40 in France and the DAX in Germany. The portfolio is uniformly constituted
of both indices. Instead of using percentages we will use a reference investment value for the
VaR computation. For simplicity, we used a reference of one million. We will use a time horizon
of 501 days since it is commonly used by risk managers. It involves the creation of 500
scenarios which is significant to illustrate the probability distribution of the change in the value

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of the portfolio. Our observations of historical data on the closing prices of both indices started
on September 12, 2011 up to September 10, 2013. Adjusting the indices was not needed; both
are in euros. We will estimate in the first step the VaR at the 99th percentile so that we are sure
up to 99% that the loss on these markets will not exceed the VaR if the changes in the last 500
days are representative of what will happen today and tomorrow. Algebraically, each scenario is
calculated as:

= (4)
1

Where represents the value of the market variable on day i assuming that September 10, 2013
is Day n. Therefore the value of the ith scenario assumes that the value of the market variable
tomorrow is calculated as per equation (4). Based on each scenario the corresponding value of
each portfolio was then calculated with reference to the indices original values of September 10,
2013. Losses and gains (defined as negative losses) are calculated based on the original reference
investment value. Table 1 summarizes the Gain/loss output.

Table 1: Gain/ Loss Variable Summary

One Variable Summary In
Mean -956.48
Std. Dev. 11,806.63
Skewness -0.19
Kurtosis 4.06
Median -894.57
Minimum -45,408.90
Maximum 40,776.72
Range 86,185.62
Count 500.00
1st Quartile -7,541.91
3rd Quartile 6,177.44
Interquartile Range 13,719.35
90.00% 12,455.81
95.00% 18,975.51
97.50% 23,119.47
99.00% 24,745.00

The one-day 99% value at risk estimated the 6th worst loss which is 24,745. The ten-day VaR
would be as per equation (1) 78,250.566 which is considered to be high and risky. The
estimates of the 99th quantile as per equation (2) was subject to 7.1% error (26,509 instead of
24,745). To this end we will calculate a confidence interval as described by Kendall and Stuart
as follow:
Assuming that the q-quantile of the distribution is estimated as x, the standard error of the
estimate is

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 1 1
= (5)
()

In our case x= 26,509, n= 500 and

f(x) is an estimate of the probability density and equal 2.257E 06 (assuming the presence of a
normal distribution even with the presence of a slight skewness). Therefore the standard error of
the estimate that is made is 1,971.18. In other words, if the estimate of the 99th percentile is
24,745, a 95% confidence interval is from 20,881 to 28,608 and the VaR of 26,509 lies
within this interval.

What we did is based on the assumption that the empirical probability distribution estimated for
both market indices over the last two years serves as a guide to the behavior of these markets
over the next day. This is a strong assumption that cannot be always observed because of the
nonstationarity behavior of these variables. To this end we will adjust for nonstationarity feature
by incorporating volatility updating as suggested by Hull J. and A. White (6).

4. Incorporating Volatility Updating

The purpose of this section is to allocate different weights for each day in the past two years.

As a first step, we use the EWMA (exponentially weighted moving average) weighting scheme
for losses where the weights decrease exponentially as we move back through time because
recent observations are more reflective of current volatilities and economic conditions
(Boudoukh et. al. (2)). The weight given to scenario i is

(1 )
(6)
1
Where n = number of scenarios = 500
We chose a value of 0.99 for the parameter (9).

We ranked losses and weights and calculated the new VaR of 24,682 for which the cumulative
weight is just greater than 0.01. We reached the 99% VaR level of both markets. This VaR is
now the seventh worst loss, not the sixth worst lost of 24,745. This slight difference is due to
the more weight allocated to the recent observations that witnessed a better performance.

Instead of using a simple weighting process, we will incorporate a volatility-updating procedure

(Hull J. and A. White (6)) such as EWMA or GARCH(1,1) and hence equation (4) for the value
of the CAC40 and the DAX under the ith scenario becomes

1 + ( 1 )+1 /
= (7)
1

Where +1 is the current estimate of the volatility of the market variable assuming now is day n.

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Hull and White produced evidence using exchange rates and stock indices to show that
incorporating volatility updating to estimate the VaR is superior to the simple historical
simulation approach and to the EWMA. Their new model incorporated the volatility changes in a
significant way so that the VaR estimates reflects more current information.
We calculated the daily percentage volatility for each market using equation (8) corresponding to
the EWMA
2 2
2 = 1 + (1 )1 (8)

With =0.939 as calculated for Paris Stock Exchange (Naimy V. (9)) and where 2 1 is defined
as the percentage change in the market variable between the end of day n-1 and the end of day n.
Figure 1 depicts the daily volatilities of both markets using the EWMA approach.

Figure 1: Daily volatility of the CAC40 and the DAX

3.00%
2.50%
2.00%
1.50%
1.00% CAC Vol
0.50% DAX Vol
0.00%
2011-11-13

2012-09-13

2012-12-13
2011-09-13
2011-10-13

2011-12-13
2012-01-13
2012-02-13
2012-03-13
2012-04-13
2012-05-13
2012-06-13
2012-07-13
2012-08-13

2012-10-13
2012-11-13

2013-01-13
2013-02-13
2013-03-13
2013-04-13
2013-05-13
2013-06-13
2013-07-13
2013-08-13

The ratios of daily volatility to the volatility of the most recent day (day n) were used as
multipliers for the changes in the indices for both markets. The volatility-adjusted loss/Gain
graph is illustrated in figure 2.

Figure 2: Volatility-Adjusted Loss/Gain per Scenario

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 Loss/Gain
80000

60000

40000

20000

0
1

81

353
17
33
49
65

97
113
129
145
161
177
193
209
225
241
257
273
289
305
321
337

369
385
401
417
433
449
465
481
497
-20000

-40000

The impact of incorporating volatility adjustments created more variability in the gains and
losses for the 500 scenarios. Therefore the one-day 99% VaR estimates is 67,499, about 2.7 as
high as the VaR estimated by the standard historical simulation. On average the daily volatility
of both markets was 1.34% for the period September 2011-2013 and therefore the use of the
volatility updating approach is more representative than the standard one.

5. Discussion and Conclusion

The purpose of this paper being the VaR estimates of the French and German stock markets, we
used the historical simulation and extended this approach to apply the EWMA weighting scheme
then the volatility updating procedure. Incorporating volatility as weight for the VaR estimation
increased the variability of losses and therefore reliability of results given the high volatility of
these two markets the last three years. Practically, these approaches illustrated the position of
some losses in the tails of the probability distribution of losses for both markets. It will be useful
to depict the output of the Extreme Value Theory (EVT) which serves to smooth the tails of the
probability distribution in a way that illustrates the shape of the tail. Such approach will help
increase the level of confidence required by risk managers up to 99.99%.
The VaR equation using the EVT is

= + 1 1 (9)

Where is the value close to the 95 percentile point of the empirical distribution,
and are the scale and the shape parameters of the distribution. When the underlying variable
v has a normal distribution, =0. However, for most financial data, is positive and in the range
0.1 to 0.4.
is the number of observations for which v > u; v being the variable under study, in our case
the loss on both markets over the last three years.

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We estimated both parameters using the likelihood methods when maximizing the below
function

1
+1
1
1+ (10)

=1

We selected u = 18,975.51 that corresponds to the 95th percentile and to =25.

The optimal value of the function in equation (10) corresponds to a = 17 and = 0.389
Based on the above parameters and using equation (11), the probability that both markets loss
per day will be more than 5% of its value (50,000) is in fact very low or impossible to happen.

1/
> = 1+ (11)

Also from equation (9) the values of the VaR with 99% and 99.99% confidence limits are
24,174 and 50,375 respectively. At the 99% confidence level the VaR estimate is close to the
8th worse loss. This is a coincidence that might not always take place.

Now that we estimated the VaR using the EVT, it becomes easy to directly estimate Expected
Shortfall (ES) referred to as conditional VaR or tail loss. Even if the VaR is an attractive measure
used to limit the risk and despite the fact that risk managers prefer to use the VaR that
compresses all the Greek letters for all the market variables underlying a portfolio in a single
number (Hull J. (4)), risk managers can still trade around. In contrast, ES produces better
incentives for those risk managers and encourages diversification. It is a function of the time
horizon and the confidence level. It is the expected loss during a given time horizon conditional
on the loss being greater than a given confidence level. ES does not have however the simplicity
of VaR and might look difficult to understand and back-test. ES is given by equation (12)

+
= (12)
1
For 99% and 99.99% confidence levels the ES for both markets are 27,511.83 and 70,393.98
respectively. In other words the expected loss on both markets is 27,511.83 per day conditional
on the loss being greater than 24,174 at a 99% confidence level. We conclude that all the VaR
measures used in this paper including the simple historical simulation, the EWMA, the volatility
updating, the extreme value theory and expected shortfall confirmed that the maximum loss on
both markets per day cannot exceed 2.41% of the portfolio initial invested amount over the last
three years. Although all of the approaches that we used in this paper produced similar 99th
percentile VaR estimates, we recommend the use of EVT in conjunction with the weighting-of-
observation procedure that combines the best features of the approaches that we examined in this
paper.

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