Practice problems

1. Consider a position consisting of a $100,000 investment in asset A and a $100,000 investment in asset B. Assume that the daily volatilities of
both assets are 1% and that the coefficient of correlation between their returns is 0.3. What is the 5-day 99% value at risk for the portfolio?
The standard deviation of the daily change in the investment in each asset is $1,000. The variance of the portfolio’s daily change is

1 0002 1 0002  2 031 0001 000  2 600 000

1,612.45 5  $3,605.55

From the tables of N(x) we see that N (233)  001. This means that 1% of a normal
distribution lies more than 2.33 standard deviations below the mean. The 5-day 99 percent value at risk is therefore 2.33×3,605.55 = $8,400.93.
2. Consider a position consisting of a $300,000 investment in gold and a $500,000 investment in silver. Suppose that the daily volatilities of
these two assets are 1.8% and 1.2%, respectively, and that the coefficient of correlation between their returns is 0.6. What is the 10-day 97.5%
value at risk for the portfolio? By how much does diversification reduce the VaR?
The variance of the portfolio (in thousands of dollars) is
2 2 2 2
0018 300  0012 500  2300500 06 0018 0012  10404
The standard deviation is 10404  102 . Since N (196)  0025 , the 1-day 97.5% VaR is
102196  1999 and the 10-day 97.5% VaR is 10 1999  6322 . The 10-day 97.5% VaR is therefore $63,220.

The 10-day 97.5% value at risk for the gold investment is 5 400  10 196  33 470 .

The 10-day 97.5% value at risk for the silver investment is 6 000  10 196  37188 . The
diversification benefit is
33 470  37188  63 220  $7 438
3. Suppose that the price of gold at close of trading yesterday was $600, and its volatility was estimated as 1.3% per day. The price at the close
of trading today is $596. Update the volatility estimate using the EWMA model with   094 .
The return on gold is
4  3600  000667 . Using the EWMA model the variance is updated to

094 00132  006 0006672  000016154

4. Suppose that each of two investments has a 4% chance of a loss of $10 million, a 2% chance of a loss of $1 million, and a 94% chance of a
profit of $1 million. They are independent of each other.
(a) What is the VaR for one of the investments when the confidence level is 95%?
(b) What is the expected shortfall when the confidence level is 95%?
(c) What is the VaR for a portfolio consisting of the two investments when the confidence level is 95%?
(d) What is the expected shortfall for a portfolio consisting of the two investments when the confidence level is 95%?
(e) Show that, in this example, VaR does not satisfy the subadditivity condition whereas expected shortfall does.

(a) A loss of $1 million extends from the 94 percentile point of the loss distribution to the 96 percentile point. The 95% VaR is therefore $1
million.
(b) The expected shortfall for one of the investments is the expected loss conditional that the loss is in the 5 percent tail. Given that we are in the
tail there is a 20% chance than the loss is $1 million and an 80% chance that the loss is $10 million. The expected loss is therefore $8.2 million.
This is the expected shortfall.
(c) For a portfolio consisting of the two investments there is a 0.04 × 0.04 = 0.0016 chance that the loss is $20 million; there is a 2 × 0.04 × 0.02
= 0.0016 chance that the loss is $11 million; there is a 2 × 0.04 × 0.94 = 0.0752 chance that the loss is $9 million; there is a 0.02 × 0.02 = 0.0004
chance that the loss is $2 million; there is a 2 × 0.2 × 0.94 = 0.0376 chance that the loss is zero; there is a 0.94 × 0.94 = 0.8836 chance that the
profit is $2 million. It follows that the 95% VaR is $9 million.
(d) The expected shortfall for the portfolio consisting of the two investments is the expected loss conditional that the loss is in the 5% tail. Given
that we are in the tail, there is a 0.0016/0.05 =
0.032 chance of a loss of $20 million, a 0.0016/0.05 = 0.032 chance of a loss of $11 million; and a 0.936 chance of a loss of $9 million. The
expected loss is therefore $9.416.
(e) VaR does not satisfy the subadditivity condition because 9 > 1 + 1. However, expected shortfall does because 9.416 < 8.2 + 8.2.
5. Suppose that the price of an asset at close of trading yesterday was $300 and its volatility was estimated as 1.3% per day. The price at the
close of trading today is $298. Update the volatility estimate using
(a) The EWMA model with  = 0.94
(b) The GARCH(1,1) model with  = 0.000002,  = 0.04, and  = 0.94.
The proportional change in the price of the asset is rn-1 = (298-300)/300 = −2/300 = −0.00667.
(a) Using the EWMA model the variance is updated to 0.94 × 0.0132 + 0.06 × 0.006672 = 0.00016153
so that the new daily volatility is 0.00016153 = 0.01271 or 1.271% per day.
(b) Using GARCH (1,1) the variance is updated to 0.000002 + 0.94 × 0.0132 + 0.04 × 0.006672 =
0.00016264
so that the new daily volatility is 0.00016264 = 0.1275 or 1.275% per day.
6. Suppose that the parameters in a GARCH(1,1) model are  = 0.03, = 0.95 and  = 0.000002.
(a) What is the long-run average volatility?
(b) If the current volatility is 1.5% per day, and today’s stock return is 3%, calculate the new estimate of volatility using the GARCH (1,1)
model.
(a) The long-run average variance, VL, is
 0.000002
1  0.02  0.0001
The long run average volatility is 0.0001 = 0.01 or 1% per day.

(b) Using GARCH (1,1) the variance is updated to