2
$\begingroup$

I'm faced with the formula shown in the image below, which I just don't understand, in part because I've no grounding in stats, and in part because I don't even understand the notation:

enter image description here

What's going on here? Is this showing in the first line how to compute the VaR, and then in the second line how to derive the annualized volatility from some of the variables used in the first computation?

I don't even understand the "T time intervals of 1/m years" part. What's an "mth" of a year? And what does $\sigma_{\frac{1}{m}}$ mean? Is that the volatility for one time period? If so, then don't we need to aggregate the values for all the discrete time periods somehow? I'd expect to see a "sum from 1 to m" somewhere...

I'm totally confused, and any help would be very gratefully received.

$\endgroup$
1
  • $\begingroup$ looks like the EWMA/VaR model $\endgroup$
    – pyCthon
    Sep 20, 2012 at 3:31

1 Answer 1

2
$\begingroup$

I guess you want to calculate vola pa for SRRI. The logic is the following:

  1. If you have a VaR Limit for $1/m$ th of a year (e.g. if $m = 12$ then for one month which is equivalent to $20$ banking days) and the risk free interest rate for a $1/m$ th of a year, this is $rf_{1/m}$ in the formula (e.g. $1$ month LIBOR), then $T=20$ and you can calculate the volatility for $20$ days, this is $\sigma_{1/m}$ ,which is implied by your VaR Limit.
  2. You calculate a vola pa from it. If you calculate with $20$ days in step 1 then you have $1/m = 1/12$ and you can calculate your annual volatility by multiplying the $20$-days volatility by $\sqrt{12}$ because the year has $12$ months. Take care: this assumes uncorrelated monthly returns all having the same volatility.

EDIT: There is mix up in this answer between $T$ and $m$. Calculating the VaR with daily data we need $T=20$ and then we annualize the volatility implied by the VaR-Limit by scaling with $\sqrt{250}$.

$\endgroup$
9
  • $\begingroup$ Reading it again I see that there is a mix up. In your screenshot and in my answer. The best is if you read the correct formula in The Esma publication on page 14. $\endgroup$
    – Richi Wa
    Sep 20, 2012 at 10:51
  • $\begingroup$ In the ESMA publication above VaR is calculated using weekly data. Then $T=4$ for a monthly (e.g. $20$ days) VaR and then you see the scaling by $\sqrt{52}$ because the year has $52$ weeks- $\endgroup$
    – Richi Wa
    Sep 20, 2012 at 10:57
  • $\begingroup$ Thanks. You're edging me towards enlightenment, but I still don't understand a couple of points: (a) If $\sigma_{\frac{1}{m}}$ is a single value, then presumably the rf bit is also a single value? But the text seems to imply that it's several values: "the risk free rate for each of the T intervals of 1/m years"? Or am I reading that wrong, and it just means that we should use the same value for each period? $\endgroup$
    – Sloucher
    Sep 20, 2012 at 21:53
  • $\begingroup$ (b) if the formula only deals with single values, that makes it easier, and I can see how you can get the VaR based on the three inputs (volatility, risk-free rate and T). But how can that be solved for volatility given a particular value for VaR? $\endgroup$
    – Sloucher
    Sep 20, 2012 at 21:56
  • 1
    $\begingroup$ I applied the formula for the quadrativ equation. It has 2 solutions but only one is positive. If I didn't make any mistake then $$\sigma = \frac{-q \sqrt{T} + \sqrt{q^2 T+2 rT^2 + 2 T VaR}}{T}, $$ where $q= 2.33$ or any other quantile, $VaR$ is clear and $r$ is the risk free rate. $\endgroup$
    – Richi Wa
    Sep 25, 2012 at 9:00

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.