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Market Risk Analysis Volume IV: Value-at-Risk Models by Carol Alexander

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IV.2

Parametric Linear VaR Models

IV.2.1 INTRODUCTION

The parametric linear model calculates VaR and ETL using analytic formulae that are based on an assumed parametric distribution for the risk factor returns, when the portfolio value is a linear function of its underlying risk factors. Specifically, it applies to portfolios of cash, futures and/or forward positions on commodities, bonds, loans, swaps, equities and foreign exchange. The most basic assumption, discussed in the previous chapter, is that the returns on the portfolio are independent and identically distributed with a normal distribution. Now we extend this assumption so that we can decompose the portfolio VaR into VaR arising from different groups of risk factors, assuming that the risk factor returns have a multivariate normal distribution with a constant covariance matrix. We derive analytic formulae for the VaR and ETL of a linear portfolio under this assumption and also when risk factor returns are assumed to have a Student t distribution, or a mixture of normal or Student t distributions.

In bond portfolios, and indeed in any interest rate sensitive portfolio that is mapped to a cash flow, the risk factors are the interest rates of different maturities that are used to both determine and discount the cash flow. When discounting cash flows between banks we use a term structure of LIBOR rates as risk factors. Additional risk factors may be introduced when a counterparty has a credit rating below AA. For instance, ...

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