Normal vs. Fat-Tail VaR
As an industry standard, Value at Risk (VaR) measures the worst expected loss of a portfolio over a specific time interval at a given confidence level. Most commercial risk analytics solutions measure VaR based on the thin-tailed and symmetric normal, “bell-shaped” distribution curve. These normal distribution assumptions result in overly optimistic VaR estimates and inadequately account for extreme events - as demonstrated by the current “Brexit” crisis,
Using BISAM Cognity’s Fat-Tailed VaR methodology, large differences are observed in times of crisis between the conventional normal VaR and the Fat-Tailed VaR, with the normal model failing to predict extreme events.
This is quite evident in the below comparison of Normal VaR vs. Fat-Tail VaR for the S&P 500.
BISAM Daily Risk Statistics - Normal Vs. Fat-Tailed VaR
My colleague Nikolay Nedelchev from BISAM's Client Services team took a look at the above Normal vs. Fat-Tail VaR spread on the S&P 500 over the last month, and pointed out the following observations:
- The VaR updates have adjusted for Friday’s reaction to the EU Referendum vote, with the fat-tailed VaR nearly double that of the Normal VaR as of today, June 27, 2016. This further underscores that Normal VaR does not accurately capture extreme events.
- Friday’s “Brexit” events led to the first fat-tail exceedance since September 2015 when the Chinese economy created seismic volatility across the global markets.
- The number of fat-tailed VaR exceedances, even with Brexit (and China for that matter), remains within the confidence interval over the last year. Whereas Normal VaR exceedances have breached the confidence interval.
The most accurate estimate of downside risk available today.
BISAM’s Cognity risk management platform uses fat-tailed, asymmetrical distributions throughout our models, and incorporates the most advanced statistical methods to model extreme events, volatility clustering, regime switching and correlation shifts in times of market crisis.
Cognity risk analytics provide more accurate fat-tailed VaR estimates that do not suffer from the over-optimism of normal distributions. But Cognity goes beyond VaR and also provides the downside Expected Tail Loss (ETL) measure - the average or expected loss beyond VaR. As compared with volatility and VaR, ETL, also known as Conditional Value at Risk (CVaR) and Expected Shortfall (ES), is a highly informative and intuitive measure of extreme downside losses.
Our readers can view Cognity’s daily risk statistics, live on FinAnalytica’s website* at www.finanalytica.com, and see recent fat-tail research at blog.bisam.com/risk
*BISAM acquired FinAnalytica earlier this year. FinAnalytica's Daily Risk Statistics currently remain live at www.finanalytica.com
FinAnalytica's Cognity® platform, now part of BISAM’s suite of market-leading portfolio analytics, is a unique, comprehensive, multi-asset class solution for market risk, portfolio construction and investment decision analytics – designed specifically for the buy-side. Visit www.bisam.com/risk to request a demo.