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If we want to calculate VAR of a portfolio using variance covariance matrix (delta normal method), containing equities, forwards and options, how do we treat each asset class for making the variance covariance matrix:

  1. Equities - Take closing prices (I know)
  2. Forwards - Do we take spot prices orporated with interest rates or the forward rates calculated with Interest rate parity ?
  3. Options - No idea at all (please help me out)

Thanks.

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  • $\begingroup$ For options, in the delta method, you replace each option position with the delta-equivalent number of shares, I think. I am not an expert on this. $\endgroup$ Commented Jan 5, 2016 at 22:16

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RiskMetrics Technical Document. Chapter 6 - may help to grasp an idea of mapping instruments to relevant risk factors.

For example

  1. equity position can be mapped to EQ Risk (factor = issuerticker) and if equity_ccy is different from portfolio_ccy also FX Risk (factor = fxspotrate);
  2. fx forward can be mapped to FX Risk (factor = fxspotrate) and IR Risk (factors = rate_ccy1, rate_ccy2);
  3. for options you may approximate with delta-gamma position and map to EQ Risk (factor = issuerticker), IR Risk, Vega risk and if applicable FX Risk. Also be careful with details here (payoff type, quanto payoff, etc..)

Be aware that

method is less accurate for options and other non-linear derivatives. It also becomes less accurate at longer horizons. Therefore not recommended for long horizons, for portfolios with many options, or for assets with skewed distributions.

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  • $\begingroup$ Thank you for your valuable suggestion. But the various risks which you have mentioned to map like fx risk and IR risk in fx forward (mentioned by you in point 2), how do I map or incorporate IR and fx risk with the forward rate? I mean is there any formula for mapping or incorporating the risk???? $\endgroup$ Commented Jan 6, 2016 at 11:26