See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/275245470

Quantitative Techniques for Financial Risk Assessment: A Comparative

Approach Using Different Risk Measures and Estimation Methods

Article in Procedia Economics and Finance · December 2014

DOI: 10.1016/S2212-5671(14)00149-X

CITATIONS READS

26 2,111

2 authors:

Aida Toma Silvia Dedu

Bucharest University of Economic Studies Bucharest University of Economic Studies
32 PUBLICATIONS 395 CITATIONS 69 PUBLICATIONS 539 CITATIONS

SEE PROFILE SEE PROFILE

All content following this page was uploaded by Silvia Dedu on 25 May 2015.

The user has requested enhancement of the downloaded file.

 Available online at www.sciencedirect.com

ScienceDirect
Procedia Economics and Finance 8 (2014) 712 – 719

1st International Conference 'Economic Scientific Research - Theoretical, Empirical and Practical
Approaches', ESPERA 2013

Quantitative techniques for financial risk assessment: a comparative

approach using different risk measures and estimation methods
Aida Tomaab*, Silvia Dedua
a
Department of Applied Mathematics, Bucharest Academy of Economic Studies, Bucharest, Romania
b
Gh. Mihoc-C. Iacob”Institute of Mathematical Statistics and Applied Mathematics of the Romanian Academy, Bucharest, Romania

Abstract

The aim of this paper is to highlight and illustrate the use of some quantitative techniques for risk estimation in finance and
insurance. The first component involved in risk assessment concerns the risk measure used and the second one is based on the
estimation technique. We will study the theoretical properties, the accuracy of modeling the economic phenomena and the
computational performances of the risk measures Value-at-Risk, Conditional Tail Expectation, Conditional Value-at-Risk and
Limited Value-at-Risk in the case of logistic distribution. We also investigate the most important statistical estimation methods
for risk measure evaluation and we will compare their theoretical and empirical behavior. The quality of the risk estimation
process corresponding to the quantitative techniques discussed will be tested for both real and simulated data. Numerical results
will be provided.

© 2014
© 2014The
TheAuthors.
Authors.Published
Publishedby
byElsevier
ElsevierB.V.
B.V.Open access under CC BY-NC-ND license.
Selection
Selectionand
andpeer-review
peer-reviewunder
underresponsibility
responsibilityofofthe
theOrganizing
OrganizingCommittee
Committeeofof
ESPERA
ESPERA2013
2013.

Keywords: Risk estimation; Value-at-Risk, Conditional Tail Expectation, Conditional Value-at-Risk; Limited Value-at-Risk; Logistic
distribution;

1. Introduction

* Corresponding author. Tel.: +4-072-609-3105.

E-mail address: [email protected].

2212-5671 © 2014 The Authors. Published by Elsevier B.V. Open access under CC BY-NC-ND license.
Selection and peer-review under responsibility of the Organizing Committee of ESPERA 2013
doi:10.1016/S2212-5671(14)00149-X
 Aida Toma and Silvia Dedu / Procedia Economics and Finance 8 (2014) 712 – 719 713

The increasing complexity of the problems arising in various fields determined a strong demand for efficient
methods of decision making. At the same time, the progress of information technology determined the development
of advanced computational techniques to implement such methods. Risk assessment provides the theoretical basis
for decision making processes in finance and insurance. Risk management has received a considerable interest
among researchers in the last years. An important problem for portfolio managers, investors and financial regulators,
refers to risk modeling and estimation. In his paper, Markowitz, 1959 underlined that investors should take into
account not only the expected return, but also the variance of the return and to choose the portfolio with the highest
expected return for a given level of the variance. Generally, the mean–variance analysis is applied when the returns
are assumed to be normally distributed or when the investor’s preferences can be accurately described using the
mean and the variance. Recently, (Fulga and Dedu, 2010, Dedu and Fulga, 2011, Tudor, 2012, Toma, 2012, Toma
and Leoni-Aubin, 2013), proposed new risk measures and optimization techniques to addressing various limitations
of the mean–variance approach. In this paper we study some quantitative techniques for risk modeling and
estimation in finance and insurance. In Section 2, we study theoretical properties, the accuracy of modeling the
economic phenomena and the computational performance of different risk measures, such as: Value-at-Risk,
Conditional Tail Expectation, Conditional Value-at-Risk and Limited Value-at-Risk. In Section 3, the most
important Value-at-Risk estimation techniques are presented. In Section 4, we derive analytical formulas for Value-
at-Risk and Conditional Value-at-Risk in the case when the loss random variable follows a Logistic distribution.
Section 5 provides computational results of the case study. Section 6 presents the conclusions.

2. Risk measures used in the finance and insurance

2.1. Value-at-Risk

In the class of quantile-based risk measures, the most used is Value-at-Risk, which evaluates the maximal loss
that can occur in a time horizon with a given probability level. Let X : Ω → R a random variable defined on the
probability space (Ω, K, P), with cumulative distribution function FX(x) = P(X x), x R.

Let (0, 1). The Value-at-Risk corresponding to a random variable X at the probability level is given by:

VaR ( X ) inf x R | P( X x) .

If the random variable X has a continuous one-to-one cumulative distribution function, then VaRα(X) can be
computed as the unique solution of the equation:

VaR ( X ) FX 1 ( ) . (1)

Value-at-Risk is used for setting the capital adequacy limits for banks and other financial institutions and plays an
important role in investment, risk management and regulatory control of financial institutions.

2.2. Conditional Tail Expectation

The limitations of the most common used risk measures (like variance, which is a symmetric measure, or Value-
at-Risk, which does not take into account the extreme values) and the criticism addressed to some of these measures
(Artzner, 1999), led to the development of new risk measures, with good analytical properties.

The Conditional Tail Expectation of the random variable X at the probability level is defined by:

CTE ( X ) EX|X VaR ( X ) .

2.3. Conditional Value-at-Risk

714 Aida Toma and Silvia Dedu / Procedia Economics and Finance 8 (2014) 712 – 719

The lack of some important properties of Value-at-Risk, like subaditivity, led to the development of some new
risk measures. The Conditional Value-at-Risk measure corresponding to the random variable X and to the
probability level (0,1) is defined by:

0, x VaR ( X )
CVaR ( X ) x dFX ( x ) , where FX ( x ) FX ( x ) - .
, x VaR ( X )
1
If X is a continuous random variable, then

CVaR ( X ) E X|X VaR ( X ) .

In recent literature, we can find several representation formulas for CVaR. One of them was proposed by Acerbi
(2002) and is given by:

1
CVaR ( X ) VaR ( X ) d (2)
0

Conditional Value-at-Risk estimates the mean value of the losses greater than Value-at-Risk which can occur in a
given time horizon. If we refer to a certain probability level , VaR (X) represents the inferior bound of the
CVaR (X) measure.

2.4. Limited Value-at-Risk

Let X be a random variable with cumulative distribution function FX(x) = P(X x). Let (0,1) and l0 R, such
that the condition (C) P(X l0) > 0 holds. The ( , l0) - Limited Value-at-Risk of the random variable X
corresponding to the threshold l0 and to the probability level is defined by:

LVaR ,l0 (X ) inf x R | P(X x|X l0 ) .

We investigate some properties of LVaR risk measure and study the relationship between VaR and LVaR.

Proposition 1. For any loss random variable X, for any (0,1) and any l0 satisfying (C) we have:

LVaR ,l0 (X ) VaR ( , l0 ) ( X ), unde ( , l0 ) (1 - ) FX (l0 ). (3)

The Limited Value-at-Risk of a random variable evaluates the worst expected loss over a time period, given that
the loss random variable exceeds an upper threshold l0 at a given probability level. Since the Value-at-Risk
corresponding to the same probability level underestimates the risk level, it follows that the LVaR approach is
more realistic in risk modeling, because there always exists a certain range of losses which is of real concern for the
investor. By increasing the threshold l0 corresponding to the Limited Value-at-Risk, we obtain further information
relative to the right tail of the distribution of the loss random variable.

3. Value-at-Risk estimation methods

Since in most cases the distribution of the loss random variable is not known, the methods for computing or
approximating VaR represent very important topics. There are three main approaches for estimating VaR (Dedu and
Fulga, 2011): the parametric or analytic method, the historical simulation or empirical method and the Monte-Carlo
simulation method.
 Aida Toma and Silvia Dedu / Procedia Economics and Finance 8 (2014) 712 – 719 715

3.1. The parametric method

The parametric or analytic method requires an assumption about the statistical distribution from which data are
drawn. The advantage of parametric VaR is that relatively little information is needed to compute it. But its main
weakness is that the distribution chosen may not accurately reflect all the possible states of the market and may
under or overestimate the risk. This problem is particularly acute when using value at risk to assess the risk of
asymmetric distributions, such as portfolios containing options and hedge funds.

3.2. The historical simulation method

The historical simulation or empirical method is useful when empirical evidence indicates that we cannot make
distributional assumptions. The historical simulation method computes the hypothetical value of a change in the
current portfolio depending on historical variations of the risk factors. The great advantage of this method is that it
makes no assumption regarding the probability distribution, it only using the empirical distribution obtained from
the analysis of past data, the calculations being relatively simple. The disadvantage of the historical simulation
method lies in the fact that it predicts the future development on the basis of past data, which could lead to
inaccurate forecasts if the trend of the past no longer complies, or if the portfolio changes.
Let Lj be the loss random variable corresponding to the asset j , j 1, s . Let L1j , L2j ,..., Lnj be n independent and
identically distributed random samples of Lj and let F̂n j be the empirical cumulative distribution function of Lj.
n
1
Then we have: Fˆnj z I {L j z} , where IA represents the indicator function of the set A. The historical
n i 1
estimation of VaR involves generating n independent and identically distributed random samples of Lj, denoted as
L1j , L2j ,..., Lnj and estimating VaR ( L j ) by: vˆnj L j ( Fˆnj ) 1
min z R Fˆnj ( z ) .

We can also write:

n
1
vˆnj L j min z R I {Li z}
. (4)
n i 1
j

3.3. Monte Carlo simulation method

Monte Carlo method is helpful when the analytical approach is not applicable. The Monte Carlo method for VaR
estimation is based on the statistical simulation of the joint behaviour of all the relevant variables and uses this
simulation in order to generate future possible scenarios. This method is used in the first step of the scenario
generation technique, that means producing a large number of future price scenarios. The next step, the portfolio
valuation, consists in computing a portfolio value for each scenario. In the final step, the summary, we report the
results of the simulation, either as a portfolio distribution or as a particular risk measure. The VaR of the loss
random variable corresponding to an asset is estimated by creating a hypothetical time series of returns on that asset,
obtained by running the asset through actual historical data and computing the changes that would have occurred in
each period.

4. Risk modeling and assessment using the Logistic distribution

4.1. The Logistic distribution

The probability density function of the Logistic distribution with location parameter μ and scale parameter s is
given by:
716 Aida Toma and Silvia Dedu / Procedia Economics and Finance 8 (2014) 712 – 719

x
s
e
f ( x; , s) x
,x R; R,s 0.
s
s 1 e

Figure 1 provides the plot of the probability density function of the Logistic distribution, for different
values of the location and scale parameters.

Fig.1. The probability density function of the Logistic distribution for different values of the location and scale
parameters: μ = 2, s = 1 (red), μ = 2.5, s = 2 (orange), μ = 3, s = 1.5 (magenta), μ = 4, s = 2 (blue), μ = 6, s = 2
(green).

The cumulative distribution function of the Logistic distribution with location parameter μ and scale parameter s
is given by:

1
F ( x; , s ) x
, x R; R, s 0. (4)
s
1 e

4.2. Risk assessment using the Logistic distribution

Our aim is to derive analytical formulas for risk computation using VaR and CVaR corresponding to the loss
random variable and to the probability level . We will use the analytic method in the case when the considered
random variable can be well approximated by a Logistic distribution. Consider a set of s assets, with the asset j
giving the return Rj at the end of the investment period. We model the return Rj using a random variable, since the
future price of the asset is not known. Let Lj be the loss random variable corresponding to the asset j, j 1, s . We
will derive the analytical form of VaR risk measure of the loss random variable Lj in the case of Logistic
distribution. We will also derive the analytical expression of CVaR risk measure of the portfolio corresponding to
the probability level , as stated in the next proposition.

Proposition 2. If the loss random variable X follows a Logistic distribution with location parameter μ and scale
parameter s, then the Value-at-Risk measure of the loss random variable corresponding to the probability level is
given by:
 Aida Toma and Silvia Dedu / Procedia Economics and Finance 8 (2014) 712 – 719 717

1
VaR ( X ) s ln 1 . (5)

Proof. Let (0,1). Since the cumulative distribution function of the random variable X is one-to-one
continuous, it follows that VaR (X) is the solution of the equation (1) and using (4) it follows the conclusion.

Proposition 3. If the loss random variable X follows a Logistic distribution with location parameter μ and scale
parameter s, then the Conditional Value-at-Risk measure of the loss random variable corresponding to the
probability level is given by:

1 s
CVaR ( X ) s ln 1 ln 1 . (6)

Proof. Let (0,1). Since the cumulative distribution function of the random variable X is one-to-one continuous,
CVaR (X) can be derived using formulas (1) and (2):
1 1 1 1 s
CVaR ( X ) VaR X ( )d s ln 1 d s ln 1 ln 1 .
0 0

5. Computational results

We consider the case of a portfolio composed by s assets and evaluate the outcome of the assets using the log-
return function. Let Sj(t) be the closing price of the asset j at the moment t. The log-return of the asset j
corresponding to the time horizon [t, t +1] is defined by: R j (t ) lnS j (t 1) lnS j (t ) , j 1,s , t 0.
The loss random variable of the asset j corresponding to the time horizon [t, t +1] is given by:
L j (t ) lnS j (t ) lnS j (t 1) , j 1,s , t 0.
We used historical data available on Yahoo Finance website for a 5 years time horizon. We choose the loss
random variable on the basis of 1260 daily closing prices of the Yahoo stock, from November 28, 2008 to
November 29, 2013. The results of the Kolmogorov-Smirnov test, presented in Table 1, show that the Logistic
distribution fits best the data for the goodness of fit test.

Table 1. The results of performing distribution fitting tests

Distribution p-value Decision

Normal 0.0000 Reject
Student 0.0001 Reject
Logistic 0.1200 Accept
Weibull 0.0001 Reject

The probability density function of the estimated Logistic distribution and the histogram of the real data are
presented in Figure 2.
718 Aida Toma and Silvia Dedu / Procedia Economics and Finance 8 (2014) 712 – 719

Histograms
30

25

20

Density
15

10

0
-0,25 -0,15 -0,05 0,05 0,15
0,084250796303638

0,084250796303638 Logistic(9,339E-4;0,011)

Fig. 2. The probability density function of the estimated Logistic distribution (red line) fitting the histogram corresponding to the real data

The risk corresponding to the loss random variable was estimated using different methods and measures. The
results presented in Table 2 and Table 3 show that historical method underestimates risk. VaR, CVaR and LVaR
measures were computed using the Propositions 1, 2 and 3.

Table 2. The results obtained for the VaR computation using three estimation methods for different values of the probability level

Method = 0.90 = 0.95 = 0.99

Parametric 0.027 0.036 0.055
Historical 0.024 0.034 0.058
Monte Carlo simulation 0.028 0.036 0.060

Table 3. The values of different risk measures computed for different values of the probability level , using the parametric method

Risk measure = 0.90 = 0.95 = 0.99

VaR 0.027 0.036 0.055
CVaR 0.037 0.046 0.065
CTE 0.037 0.046 0.065
LVaR ;0.01 0.031 0.038 0.058

The results obtained indicates that LVaR approach is more realistic in risk modelling because there always exists
a certain range of losses which should be taken into account by the investor in order to evaluate risk as accurate as
possible.
 Aida Toma and Silvia Dedu / Procedia Economics and Finance 8 (2014) 712 – 719 719

Acknowledgements

This work was supported by a grant of the Romanian National Authority for Scientific Research, CNCS –
UEFISCDI, project number PN-II-RU-TE-2012-3-0007An example appendix

References
Acerbi, C., 2002. Spectral measures of risk: A coherent representation of subjective risk aversion, Journal of Banking and Finance 26, p.1505.
Artzner, P., Delbaen, F., Eber, J.M., Heath, D., 1999. Coherent measures of risk, Mathematical Finance 9(3), p. 203.
Dedu, S., Fulga, C., 2011. Value-at-Risk estimation comparative approach, with applications to optimization problems, Economic Computation
and Economic Cybernetics Studies and Research, 45, 1, p. 127.
Fulga, C., Dedu, S., 2010. A New Approach in Multi-Objective Portfolio Optimization Using Value-at-Risk Based Risk Measure, Proceedings of
The IEEE International Conference on Information and Financial Engineering, p. 765.
Markowitz, H., 1959. Portfolio selection, John Wiley & Sons, New York.
Toma, A., Leoni-Aubin, S., 2013. Portfolio selection using minimum pseudodistance estimators, Economic Computation and Economic
Cybernetics Studies and Research, 47, 1, p. 97.
Toma, A., 2012. Robust Estimations for Financial Returns: An approach based on pseudodistance minimization, Economic Computation and
Economic Cybernetics Studies and Research, 46, 1, p. 117.
Tudor, C., 2012. Active portfolio management on the Romanian Stock Market, Procedia-Social and Behavioral Sciences 58, p. 543.

View publication stats