Department of Mathematics Hong Kong University of Science and Technology MAFS 5220 Quantitative and Statistical Risk analysis

A Sequential Algorithm on Robust Value at Risk Approach with application to indexes and migration matrix risk control Huang Yuelun yhuangaa@gmail.com UG hall6 room 704

I would like to thank Prof. Ling Shiqing, Prof Jing Bingyi for their kindly and precious advice on this time series and statistical technique and Prof. Chan for his kindly guidance on the working optimization problem.

A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Content
1. 2. 3. 4. 5. 6. 7. 8. 9. Abstract ................................................................................................................ 3 background and data selecction certerion .......................................................... 4 data indetifcation and resources ......................................................................... 4 Value at Risk approach revisited ............................................................................ 6 priliminary data analysis and problem description ............................................... 9 brief introduction on time series forecasting technique ..................................... 11 The pesudo Robust Var algorithm ...................................................................... 15 Conclusion on HSI index study ............................................................................. 21 further application ............................................................................................... 23

10. Appendix & reference .......................................................................................... 26

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

1. Abstract
Value at Risk approach has been one of the most widely known risk control techniques for its simplicity, easily and widely applied nature, However, the dark side of this approach is very often criticized for its loose control in the tail events and non-sub-additivity. Although other risk measures like CVaR and EVaR are developed to successfully conquer such inconsistency. But the problem is such measures form a strict sub-additive upper bound, and it is fundamentally too conservative. It trades the profitability with risk in the strict sense. In essence, the relationship of risk and profit are not clearly solved. Both methods have advantages in certain situations but fail in other cases. Therefore they are not robust. This research project embraces an original idea, by utilizing the advanced time series technique to redevelop the VaR approach into Robust VaR (Also called for General VaR ) approach. With the advanced economy downturn detecting mechanism and volatility prediction, the methods high accuracy better balances the risk and business level than the non-robust methods. Moreover, it gives more robust defense on the downturn risk signaling and control. The method of the paper is carried in a pseudo algorithm format, it is neat and easy to implement for simplicity. Throughout the paper HSI index study will be demonstrated. Moreover the application and the prospect are also oriented. Key words: Markov switching, volatility, downturn risk, Value at risk, Robust, empirical Bayesian, asymmetric optimization

2. Background and data selection criterion

Data Selection criterion: To carry out the strategy and validate the empirical result of improved Robustized Value at risk approach, one needs appropriate data selection to back up the idea and demonstrate the result. To find the data, we need the data satisfy the following properties: 1. High liquidity with large trading volume. 2. There is no closed pricing formula and the return should subject to stochastic changes and not easy to monitor.
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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

3. The data should be taken in long time horizon and compute with quarterly horizon to stabilize the information shocks. The reason behind first requirement is that price of certain underlying are subject to effects of a lot of factors in reality. The high liquidity and large trading volume means other risks, for instance, liquidity risk and relevant are less significant so we can better monitor the risk with basic prediction of the underlying asset volatility movements. The second requirement is that the risk analytics are applied in real in the sense that people cannot form consistent predictions for the future and the pricing are at stochastic dynamics changes. The last one is a way of eliminating the white noises, since the daily return might subject to strong speculation purposes, while the quarterly returns are more stable and highly associate with the real behavior and realization of the market expectation. In below, it can be demonstrated that the HSI index is a good candidate data set and we will use it to carry out the method for demonstration purpose.

3. Data identification and collection

Heng Seng Index: A brief introduction:
The Hang Seng Index ("HSI") is one of the earliest stock market indexes in Hong Kong. Publicly launched on 24 November 1969, the HSI has become the most widely quoted indicator of the performance of the Hong Kong stock market. To better reflect the price movements of the major sectors of the market, HSI constituent stocks are grouped into Finance, Utilities, Properties, and Commerce and Industry Sub-indexes.i

High liquidity and trading volume:

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Figure 1 HSI trading volume

It can be seen that the trading volume are at least millions level per workday and the volume subjects to a steady growth in the past 10 years. With such high turnover rate, we conclude the liquidity requirement is satisfied.

Unpredictability and Risk control

To quote my second case study report, I examine through the efficient market hypothesis and found out that in reality it does worked for most of the cases, the arbitrage opportunities are eliminated to almost zero. Due to the highly diversified asset holding and sectors, the predictability of single component is extremely difficult and unstable. The time series lags (one lag unit is defined as a quarter) are very weak. This is verified by figure2. Since no strong lag implies exists no serially predictability. We can insure that Heng Seng index satisfies our second requirement. Moreover, we can also reassert that the market is efficient and any transactions associate with it subject to stochastic risk.

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control
Figure 2 ACF and PACF of the HSI quarterly return

Data Sources and basic descriptions

Heng Seng index has rather solid historical data and it is easy to found the stable result. The data below is cached from Yahoo Financeii, with the horizon from 1986/12/31 to 2013/5/1 in a monthly format and then use natural logarithmic percentage to denote quarterly rate.

4. Value at Risk approach revisited:

From my personal first report, I have been discussing the problem of Value

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

at risk approach and the standardized result attached as follow:

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

The pros and cons are demonstrated here, the VAR lacks the information of the tail distribution beyond the %, the VAR approach are Robustly practical and gives a very good result when the economics performs normally, where outliers are eliminated. The CVAR is very sensitive to outliers. It works better during the recession because the extreme values are more frequent and this method tends to overestimate the risk in the normal period. With such insights, it is natural to question whether returns come from the same stationary distribution and extreme value occurs equally by chance is a reasonable assumption. Based on my work, I suggest use empirical Bayesian,
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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

trying to utilize the best features of both by conditioning the type of the tails, i.e. the mode of economy, where whether the extreme values are possible.

5. Preliminary data analysis and problem description

Compute the VaR and CVaR of the HSI index by the normal method.

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Figure 3 empirical quantile plot of return

Figure 4 kernel density distribution

p=6 p=1 r(p) 106(10.95)

From the empirical result figure 3, we can compute VaR at 5%: -21%. CVaR at 5%: =-39.057%

Practice remark: Those results are too inconsistent, below graph(figure 4) shows the VaR, CVaR and 95% volatility level. The upper line is CVaR threshold, the lower arrow is the VaR threshold, while the shock are calculated at 95% of confidence level. The VaR underestimate the risk extensively, but the CVaR overestimate risk at all time.

Figure 5 95% volatility level, VaR and CVaR level

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

The Common VaR and CVaR exists three big problems:

The inconsistency of VaR and CVar:
VaR and CVaR are different measures, CVaR is a strict upper bound of VaR, and therefore the value of both, especially associate with large volatility, will have large difference.

whether the weights should be given in the form of exponential decay or polynomial decay is unknown:
One way to solve it is people can give different weights to historical volatility, the method shows a concern of conditioning on different situations, but it didn t go deep enough, there is no theoretical foundation given what and why the weight should be given in this way other than manipulation. Further than that, once the decay is determined, it becomes deterministic and no more flexibility is given to predict about future dynamics. Lastly, the VaR and CVaR is not local optimal: Clearly there are three major shocks in 86-88, 97-99,08-10, however our prediction is static and hence it is not really optimal at the local level, and for 00-06, the HIS are less volatile, but we predict the VaR and CVaR at the same level, it seems to be more overall efficient but less local level efficient. A Robust result for such VaR and CVaR approach can very easily create an over-specification problem. And it works very badly out of sample because of low flexibility since the method is created to fit into the overall sample and less idiosyncratic feature is considered. To conquer such problem, we will use an entirely different approach based on the very James D Hamiltons masterpiece iii on Switched Markov Process, using binjamini Hochbergs false discovery rate on detecting mechanism and Enger s Arch and Garch model for volatility forecastingiv.

6. Brief introduction of on time series forecasting techniques

A brief introduction on Arch and Garch model:

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control In econometrics, AutoRegressive Conditional Heteroskedasticity (ARCH) models are used to characterize and model observed time series. They are used whenever there is reason to believe that, at any point in a series, the terms will have a characteristic size, or variance. In particular ARCH models assume the variance of the current error term or innovation to be a function of the actual sizes of the previous time periods' error terms: often the variance is related to the squares of the previous innovations. The Garch model denotes Robustized Arch model with the setup list below arch model .In our case , we will use Garch to predict the volatility movement as a building block for risk control.

A brief introduction on Switched Markov Process:

Markov switching model specifics the mechanism of a random process the can be equal to either 0(bad economy) or 1(good economy), this denotes the different modes of the economy (in our case). Each case will be a simple AR(1) process.

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Then if we can use the data to determine the stationary Markov transition probability kernel, which at every node, we will look into future and compute whether next node will be good economy or bad economy. 00 [
01

10 11 ]= ( ) ] ( )

( ) ( )

Now with the basic setup we can carry out more Robust setup with different mode.

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

For completeness, the derivation of the mechanism is listed, the expected duration of good state or bad state are for very useful result to predict short term economics movement, the filtering probability and the optimal stationary measure is derive in the following way to detect the markov trend of economics .

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

A brief introduction on Benjamini Hochberg procedure and FDRv: The BH procedure is applied for large scale inference, the definition of False Discover Rate greatly enhance the power of the test. Below attaches the construction of such a test. In our case, we will test the

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

threshold probability level for recession and use such inference as an alternative detecting mechanism to optimization method.

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

7.The Pseudo Robust VaR Algorithm Step 1: check for GARCH effect. , = { , = ,
ARCH effect is method is used to check whether the volatility are constant during the process, this is very important for Value at Risk approach since the standard-deviation accounts for the loss we are interested in, therefore we must forecast the volatility movement. For the HSI index future, the ARCH effect is very clearly exists (see figure 5), the constant volatility prediction is no good. Since the p-value is around 0.3 we dont reject the arch effect exists (more in appendix). The volatility effect existed and non-constant is also verified by (figure 6). And the predictability is not very good and it subjects to strong volatility movement.

Figure 6 Arch statistics

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Figure 7 fitted and risdual graph assume no arch effect

Step 2: Fit an Optimal grach model to predict the volatility.

Based on AIC criterion, the model fitted below Cgarch(1,1) (figure 8) ,The model forecast statistics (figure 9) conditional standard deviation (figure 10)

Figure 8 Cgarch model

Model prediction:

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Figure 9 model statistics and forecasting

Figure 10 conditional standard variance prediction

Using the model prediction we can demonstrate the path dependent conditional variance with 1 quarter ahead forecasting above. Denote the predicted conditional variance

Step 3: Work out Markov Switching model

Here is the estimated HSI index Markov transition probability kernel (figure 11) and the expected duration (figure 10) which accounts for the mean expected time for each mode. The regime specification on (figure 12), state 1 is good and state 2 is bad. To demonstrate the power of such method, the HSI historical index price are plot and shaded for the crisis on (figure 13) the Markov switching auto regression are specified on (figure 14) with the filtered probability

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Figure 11 expected mode duration

Figure 12 markov transition probability kernel

Figure 13 markov regime specification

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Figure 14 historical HSI price shaded for crisis

Figure 15 Filtered probability shaded for stated 2

Step 4: Robust VaR threshold model and BH procedure Basic notation and description:
S(t)=1 denotes good state, S(t)=2 denotes bad state x denotes the one-step forecast probability ending in state 2 y denotes the realized filtered probability for state 2 () = { , , .

VaR =1.645* Where is the result derived as constant from step 1 or Garch prediction step 2 For demonstration purpose the is set at 5%
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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

The threshold model:

Function specification: In below we define the objective function ( )={ , ,

( , ):

, ( ) ( . ), Where 0.4 is a cut-off probability value in mode 2. ( , )={ Threshold={ ( , )}

From the historical data, the threshold is 0.24 meaning that: predi ted e o o t te S (t + ) = , (S (t + ) = 2 S (t ) = ) ={ S(t + ) = 2, (S(t + ) = 2 S(t) = )

.2 .2

The BH procedure:

In this case, the FDR is set to be 25%. This means the wrong detection (good state is predicted to be bad) has a probability of 25%, we dont
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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

want to make too much wrong detection because this will eliminate the business opportunity, but too few detection will cause a higher significant level of downturn prediction, which will not be accurate. This is trade-off for the user, but it does allow great flexibility. In this setting the C is 22%, compare to the asymmetric model. Robust VaR application: Robust VaR prediction definition condition on good state:
o t r={ r= . r+( , ) { (S (t + ) = ) , { (S(t) = ) ( )= } (t ) = }

Where is the result derived as constant from step 1 or Garch prediction

step 2 If the economy is at state 2, the bad state: The kernel is very hard to monitor and for simplicity we use expectation. { (( + ) = 2|(( ) = 2)) = .3 89 7 (( + ) = |(( ) = 2)) = . 3

Robust VaR prediction condition on bad state:

r= (

)=

+(

8. Conclusion on HSI index study

Out of sample validation: The data is utilized till the 2013/4/1, with the fitted model above. The one step bad economy forecast probability is see (figure 16) : (( + ) = 2|(( ) = )) = . 9, which is below both thresholds solved for both detection bound, therefore we conclude there is no sign indicates downturn trend. The HSI out of sample performance is listed below (figure 17). One can fit an up-trend line for validation; therefore we conclude the result is valid. But if on the other hand, the company is more focused on high-frequency trading, more delicate risk control technique for short time horizon could be build based on the framework.

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Figure 16 one step 2013 second quarter bad economy probability forecasting

Figure 17 out of sample validation

Final result Demonstration and discussion: (In graph the General VaR denotes Robust VaR)
In figure 18, the HSI return, CVaR,VaR and the Robust VaR is plot for comparison, it is seen that the Robust Var provides good performance. Firstly, it provides accuracy, at 95% level; the crossing is only twice, for large-scale speculation and extreme downturn. Secondly, it gives business dynamics by lower risk bound. Thirdly, unless extreme downturn occurs, the model handles
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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

normal business cycle downturn well. e.g.1998, 2000-2003, 2011. Last but not least, more flexibility is allowed for extreme downturn without hurt the normal period. In Figure(19 and 20), CVaR captures the extreme value. But reconditioning on CVaR level, we can give more tolerance on extreme crisis. The NNSD is predicted by Garch, the difference between it with Robust VaR is determined by downturn detecting mechanism and the risk aversion level or trade off prediction accuracy level against the bad periods. By reconditioning the parameter the method gives a better downturn management performance.

Figure 18 Method comparison

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Figure 19 Garch prediction and MS model switching model CVar=39

Figure 20Garch prediction and MS model switching model CVar=45

The HSI study result is very good; this method not only can be converted into sequential algorithm but also introduce dynamics adjustment into Risk management,

9. Further Application and prospect:

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

The key result embedded in this study is the economy downturn detecting mechanism, this method is fundamentally important in stress testing and scenario analysis, we can build different scenarios directly into the model and system without needs to re- parameterize the model and concern about the inconsistency of the estimation.

On migration matrix:
It is well-known that many securities are subject to economy downturn risk; corporate bond defaults, CMO defaults and various are all subject to the business cycle and the effect is significant. For migration matrix, we can apply the same argument: consider normal predicted migration matrix A = ( ) and distressed predicted migration matrix D = ( ).

Follow similar argument. Firstly, detect the downturn risk and then determine a downturn transition probability threshold from historical data. The new migration matrix can be carried out as followings: A, ( (t + ) = d ) thre hold ={ A + ( )D, otherwi e Where is a weight coefficient depending on the risk aversion level or use BH procedure set equals to the trade off FDR to validate the argument for more flexibility.

Prospect:
For the moment, all the work are carried out for single setting, if the portfolio are highly diversified, in a high dimension space, one can either run a Markov switching Vector auto regression model, and the state space can be more than 2 to catch up with the situation closely. Or one can still predict only the economy downturn risk, use the component analysis to work out the portfolio risk conditioning on the downturn. Survival analysis can also be used for the expected duration to measure the switching pressure. If on the other hand, the company is more focused on high-frequency trading, more delicate risk control technique for short time horizon could be build based on the framework use the Garch model to decompose the white noise process.

10. Appendix & Reference:

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

HSI data analytics:

Figure 21 arch lag test

Figure 22 Cgarch parameters estimation table

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A Sequential Algorithm on Robust Value at Risk Approach With application to indexes and migration matrix risk control

Figure 23 Markov switching AR proces

i

http://www.hsi.com.hk/HSI-Net/HSI-Net http://finance.yahoo.com/q/hp?s=%5EHSI+Historical+Prices

ii

iii

Hamilton J D. A new approach to the economic analysis of nonstationary time series and the business cycle[J]. Econometrica: Journal of the Econometric Society, 1989: 357-384. iv Bollerslev T, Engle R F, Nelson D B. ARCH models[J]. 1994. Engle R F, Kroner K F. Multivariate simultaneous Robustized ARCH[J]. Econometric theory, 1995, 11(01): 122-150.
v

Benjamini Y, Hochberg Y. Controlling the false discovery rate: a practical and powerful approach to multiple testing[J]. Journal of the Royal Statistical Society. Series B (Methodological), 1995: 289-300.

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