How to Choose the Return Model for Market Risk? Getting Towards a Right Magnitude of Stressed VAR

24 Pages Posted: 15 Nov 2017 Last revised: 4 Dec 2017

Date Written: November 11, 2017

Abstract

Value at Risk (VaR) and stressed value at Risk (SVaR) or expected shortfall are important risk measures widely used in the financial services industry for risk management and market risk capital computation. Fundamental to any (S)VaR model is the choice of the return type model for each risk factor. Because the resulting SVaR numbers are highly sensitive to the chosen return type model it is important to make a prudent choice on the return type modelling. We propose to reconstruct the return type model from historic data without making an a priori model assumption on the return model. We explain the fundamentals of return type modelling and how it impacts magnitude of SVaR. We further show how to obtain a global return type model from a set of similar return type models by using geometric calculus. Numerical simulations and illustrations are provided. In this paper the focus is on interest rates, but the proposed methodology is general and can be applied to any other asset class such as inflation, credit spread, equity or fx.

Keywords: VaR, SVaR, value at risk, stressed value at risk, fundamental review of the trading book, FRTB, interest rates, local volatility, normal, lognormal, relative, absolute, displaced, risk factor returns, model risk, return modelling, geometric calculus, nature of interest rates

Suggested Citation

Lichtner, Mark, How to Choose the Return Model for Market Risk? Getting Towards a Right Magnitude of Stressed VAR (November 11, 2017). Available at SSRN: https://ssrn.com/abstract=3069938 or http://dx.doi.org/10.2139/ssrn.3069938

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