A multi-factor model for the risk management of portfolios

We propose a methodology for modelling the value at risk of a complex portfolio, based on an extension of the Ho, Stapleton and Subrahmanyam technique. We model the variance‐covariance structure of up to seven variables. These could represent four country indices and three exchange rates, for example. In addition, the effect of an arbitrary number of orthogonal factors can be analysed. The system is illustrated by estimating the value at risk for a portfolio of international stocks where the factors are stock market indices and exchange rates, a portfolio of international bonds where the factors are interest rates as well as exchange rates, and a portfolio of interest rate derivatives in different currencies. In this last case, we model a two‐factor term structure of interest rates in each of the currencies, valuing the derivatives at a future date using these term structures and the Black model. The model is applied for different fineness of the binomial density and computational accuracy and efficiency are estimated. G13, G15, G21