The Effect of Mis-Estimating Correlation on Value-at-Risk

Posted: 2 May 2005

See all articles by Vasiliki D. Skintzi

Vasiliki D. Skintzi

Athens University of Economics and Business - Department of Management Science and Technology

George S. Skiadopoulos

University of Piraeus, Department of Banking and Financial Management; Queen Mary, University of London, School of Economics and Finance

Apostolos N. Refenes

Athens University of Economics and Business - Financial Engineering Research Centre

Abstract

This paper examines the systematic relationship between correlation mis-estimation and the corresponding Value-at-Risk (VaR) mis-calculation. To this end, first a semi-parametric approach, and then a parametric approach is developed. Both approaches are based on a simulation setup. Various linear and non-linear portfolios are considered, as well as variance-covariance and Monte-Carlo simulation methods are employed. We find that the VaR error increases significantly as the correlation error increases, particularly in the case of well-diversified linear portfolios. In the case of option portfolios, this effect is more pronounced for short-maturity, in-the-money options. The use of MC simulation to calculate VaR magnifies the correlation bias effect. Our results have important implications for measuring market risk accurately.

Keywords: Value-at-Risk, Correlation Mis-Estimation, Monte Carlo Simulation, Variance-Covariance Methods, Model Error

JEL Classification: C15, G10, G13, G21

Suggested Citation

Skintzi, Vasiliki D. and Skiadopoulos, George and Skiadopoulos, George and Refenes, Apostolos N., The Effect of Mis-Estimating Correlation on Value-at-Risk. Available at SSRN: https://ssrn.com/abstract=709541

Vasiliki D. Skintzi

Athens University of Economics and Business - Department of Management Science and Technology ( email )

47A Evelpidon & Lefkados 33
Athens GR-11362
Greece
+3210 8203678 (Phone)

George Skiadopoulos (Contact Author)

University of Piraeus, Department of Banking and Financial Management ( email )

80 Karaoli & Dimitriou Str.
18534 Piraeus, 185 34 -GR
Greece

HOME PAGE: http://https://sites.google.com/view/george-skiadopoulos

Queen Mary, University of London, School of Economics and Finance

Lincoln's Inn Fields
Mile End Rd.
London, E1 4NS
United Kingdom

Apostolos N. Refenes

Athens University of Economics and Business - Financial Engineering Research Centre ( email )

Department of Management Sciences and Technology
47A Evelpidon & 33 Lefkados
GR-10434 Athens
Greece

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