Python for Finance

Risk Measurement

Andras Niedermayer
Outline

1 Risk Measures

2 Parametric VaR, ES

3 Monte Carlo Simulation

4 Historical method

Wednesday, April, 2019 Python for Finance - Lecture 9

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Motivation

• In quantitative finance arguably the most important

task/challenge is the financial risk measurement and assessment.
The majority of the financial engineer’s task is connected to this
field.
• Risk Measurement for a financial institution is very data intense
and computational expensive process.
• Using the adequate, state of the art technologies are key to keep
up with the speed of the financial market innovation, and to be
able to meet the regulatory requirements.

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Types of risk measures

There is a wide range of risk measures that spread through the

Market.
• Volatility (σ)
• Value at Risk (VaR)
• Expected Shortfall (ES)
• Conditional Value at Risk (CVaR) - In case of continuous
distributions same as ES
• Average Drawdown, Maximum Drawdown
• etc.

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VaR and ES

Formal definitions:
1 Value at Risk:

VaRα (X ) = − inf{x ∈ R : FX (x) > α} = −FX−1 (α) (1)

2 Expected Shortfall:
ESα (X ) =
1
− [E (X ∗ 1{X ≤−VaRα (X )} ) − VaRα (X )(α − P(X ≤ −VaRα (X )))]
α
(2)
1 α
Z
= VaRp (X )dp (3)
α 0

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Python Implementation

1 def compute_var (x , alpha ):

2 return - np . percentile (x , alpha *100.0)
3 def compute_es (x , alpha ):
4 x_alpha = - compute_var (x , alpha )
5 prct = sum (x <= x_alpha )/ float ( len ( x ))
6 y = x * ( x <= var_alpha )
7 es = -1.0/ alpha *( y . mean ()+
8 x_alpha *( alpha - prct ))
9 return es

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Outline

1 Risk Measures

2 Parametric VaR, ES

3 Monte Carlo Simulation

4 Historical method

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Parametric VaR, ES
1 From historical prices we need to calculate the returns:
1 rets = np . log ( S ) - np . log ( S . shift (1))
2 rets = rets [1:]

2 Assuming Normal distribution (r ∼ N(µ, σ 2 )), we need to

estimate the parameters:
1 mu = rets . mean ()
2 sigma = rets . std ()

3 Use the closed form solution to calculate the VaR and ES:
1 var = - scs . norm . ppf ( alpha , loc = mu ,
2 scale = sigma )
3 es = scs . norm . pdf ( scs . norm . ppf ( alpha ))*
4 1/ alpha * sigma - mu
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Normality assumption

Many influential theories in finance assume the normality of stock

returns:
1 Portfolio theory and CAPM: Normality of returns implies that
only the mean and variance are relevant for portfolio
optimization.
2 Option pricing theory: The Black and Scholes model, and many
other pricing models assume (log-)returns follow a Brownian
motion, i.e., are normally distributed over any given time
interval.
Is normality a realistic assumption? How to test for it?

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 Benchmark: Simulated data

Let us simulate 10,000 stock price paths from a Geometric Brownian

motion, and save the log returns.
1 def gen_paths ( S0 ,r , sigma , T ,M , I ):
2 dt = float ( T )/ M
3 paths = np . zeros (( M +1 , I ))
4 paths [0]= S0
5 for t in range (1 , M +1):
6 rand = np . random . randn ( I )
7 paths [ t ]= paths [t -1]*
8 np . exp (( r -0.5* sigma **2)* dt
9 + sigma * np . sqrt ( dt )* rand )
10 return paths
11 paths = gen_paths (100 ,0.05 ,0.2 ,1.0 ,50 ,10000)
12 log_returns = np . log ( paths [1:]/ paths [0: -1])

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Informal tests of normality

Graphically, one can assess (non-)normality of data via two types of

plots:
1 Histograms.
1 plt . hist ( log_returns . flatten () , bins =100 ,
2 normed = True )

2 QQ (quantile-quantile) plots.
1 sm . qqplot ( log_returns . flatten ())

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Formal tests
• We need to import the [Link] sublibrary.
1 import scipy . stats as scs

• Skewness and skewness test (returns test value and p-value).

1 scs . skew ( log_returns . flatten ())
2 scs . skewtest ( log_returns . flatten ())

• Kurtosis (normalized to 0) and kurtosis test (returns test value

and p-value).
1 scs . kurtosis ( log_returns . flatten ())
2 scs . kurtosistest ( log_returns . flatten ())

• Catch-all normality test (returns test value and p-value), based

on D’Agostino and Pearson (1973).
1 scs . normaltest ( log_returns . flatten ())
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Real-world data: the S&P 500 index

We want to see whether the S&P 500 returns are also normally
distributed.
1 plt . hist ( sp_returns , bins =50 , density = True )
2 sm . qqplot ( sp_returns )

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Normality tests on S&P 500 data

The S&P 500 data have negative skewness (i.e., the returns are not
symmetric around the mean), and they also have excess kurtosis (fat
tails: excessive extreme returns). Therefore, it fails the normality test.

Measure Value Test statistic p-value

Skewness -0.943 -7.943 1.96e-15

Kurtosis 5.540 8.673 4.19e-18

Normality 138.3 9.18e-31

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Outline

1 Risk Measures

2 Parametric VaR, ES

3 Monte Carlo Simulation

4 Historical method

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Monte Carlo Simulation

1 Similarly to Parametric calculation the Monte Carlo simulations

are also driven by an assumed distribution. In case of Normality
assumption we can estimate the parameters similarly to the
Parametric case.
2 Generating random numbers based on the given distribution
3 Generating return paths
4 Calculate Risk Measures

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Built in random number Generators

1 import numpy . random as npr

2 # Normal distribution
3 r = npr . normal ( loc = mu , scale = sigma , size =( T , N ))
4 R = npr . multivari a t e_ n o rm a l ( mean , cov , size )
5 # Log - Normal distribution :
6 r = npr . lognormal ([ mean , sigma , size ])
7 # Student - t distribution
8 r = npr . standard_t ( dof , N )

Full list: [Link]

reference/[Link]

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Path generation with pre-generated returns

1 def make_path (R , S0 =1 , b_return_path = True ):

2 # R . shape = [T , N ]
3 R_with_0 = np . zeros (( R . shape [0]+1 , R . shape [1]))
4 R_with_0 [1: ,:] = R
5 c umulative_r et ur ns = R_with_0 . cumsum ( axis =0)
6 if b_return_path :
7 return np . exp ( c um ul at iv e_ re tu rn s )* S0
8 else :
9 return c um ul at iv e_ re tu rn s

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Standardizing variables – mean
Let us generate 100 standard normal variables:
1 X = npr . randn (100)

Especially in small samples, the sample mean and variance will not be
zero and one!
1 X . mean ()= -0.128
2 X . std ()=1.015

Mean adjustment
First, we can normalize the mean by subtracting it from each element:
1 X1 =X - X . mean ()
2 X1 . mean ()=5.16 e -17
3 X1 . std ()=1.015

This solves the mean issue, not the standard deviation!

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Standardizing variables – variance

Variance adjustment
Second, we can normalize the variance by dividing each element with
the standard deviation:
1 X2 = X1 / X . std ()
2 X2 . mean ()=5.16 e -17
3 X2 . std ()=1.000

Or, directly:
1 X3 =( X - X . mean ())/ X . std ()

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Antithetic variables

Exploiting the feature of a distribution where the transformation of

the variable leads to a similar distribution, we can
• significantly speed up the simulation procedure
• reduce the error of the Monte Carlo Simulation
In case of normal distribution:
X ∼ N(0, σ 2 ), Y := −X ⇒ Y ∼ N(0, σ 2 )

VaR with Antithetic variate

1 rets = npr . randn ( n )
2 [ pct_up , pct_down ] =
3 np . percentile ( rets , [ alpha , 100.0 - alpha ])
4 var = -( sigma *( pct_up - pct_down )/2+ mu )

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GARCH model

The Generalised Autoregressive Conditional Heteroskedasticity

model, or GARCH:
1 Allows the volatility of returns to be time-dependent, following a
AR process.
2 Therefore, it is a suitable model to account for the empirical
observation of volatility clustering
3 Clustering: Periods of high volatility are likely to be followed also
by periods of high volatility.
4 An important note is that the volatility is non-stochastic!
5 Estimation of GARCH is done by maximum likelihood.

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GARCH specification

Let stock (index) returns be given by:

rt = µ + t , where t ∼ N 0, σt2


(4)

The variance dynamics is:

σt2 = ω + α2t−1 + βσt−1

2
(5)

For the model to remain stationary (variance does not explode) we

require:
α + β < 1. (6)
There are four parameters to estimate: µ, ω, α, β.

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GARCH in Python
The arch package contains the tools for GARCH analysis. It can be
downloaded by pip install (available for Python 2 and 3 as well).
1 from arch import arch . model

First we need to define the model that we would like to estimate.

Default is GARCH(1,1).
1 am = arch_model ( returns )

Then we can estimate the model parameters. The default estimation

methodology is Maximum Likelihood.
1 res = am . fit ()
2 res . summary ()

Then using the forecast method we can generate log-returns:

1 fcast = res . forecast ( method = ’ simulation ’ ,
2 simulations =N , horizon = days )
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Conditional Volatility of Facebook

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Effect of ”GARCH” on Facebook

Comparing Facebook VaR and ES with and without GARCH(1,1)

GARCH Normal
VaR95 0.0387 0.0248

ES95 0.0474 0.0313

VaR99 0.0514 0.0354

ES99 0.0605 0.0407

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Outline

1 Risk Measures

2 Parametric VaR, ES

3 Monte Carlo Simulation

4 Historical method

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Bootstrap Method

1 There is no assumption on the return distribution, so no

parameter estimation is required. It will use the historical
distribution.
2 Random sampling on the historical returns. NOTE: Keep the
Correlation structure!
3 Generate return path
4 Calculate Risk Measures

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Random sampling

The fastest way to generate random sample of historical returns, we

can assign an integer for each observation time, and using a random
sampling algorithm we can generate a the set of simulated returns.
1 df2 = df . reset_index ()
2 nr_of_rets = len ( df2 )
3 return_indexes =
4 npr . choice ( range ( nr_of_rets ) , N )
5 retruns = df2 . loc [ return_indexes ]

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Backtesting VaR

The Basel Committee introduced a VaR Backtest Methodology in the

Basel regulation, which is called the BIS Traffic Light System. Their
approach is based on how many breach would happen in the 1 day
99% VaR value today, if the last 250 days return scenario would
repeat.

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BIS Traffic Light System

Zone Breach Value Cummulative Probability

Green 0 8.11%
Green 1 28.58%
Green 2 54.32%
Green 3 75.81%
Green 4 89.22%
Yellow 5 95.88%
Yellow 6 98.63%
Yellow 7 99.60%
Yellow 8 99.89%
Yellow 9 99.97%
Red 10+ 99.99%

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 Thank you for you attention!

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