Empirical evaluation of value at risk (VaR) models using the Lusaka stock exchange.

By

[Name of the Author]

[Name of the Department]

Abstract

In this paper various Value-at-Risk techniques are applied to the Lusaka stock market index LUSE and to the Dow Jones Industrial Average. The main findings are: (1) Changing volatility over time is the most important characteristic of stock returns when modeling value-at-risk; (2) For low confidence levels, the fat tails of the distribution can best be modeled by means of the t-distribution; (3) Tail index estimators are not successful, due to the fact that they cannot cope with the volatility clustering phenomenon. The study has been concerned with the Value-at-Risk analysis of the stock market. A wide variety of Value-at-Risk models has been presented and empirically evaluated by applying them to a fictitious investment in the Lusaka stock market index LUSE, mainly for illustrative purposes. Subsequently, a more rigorous approach was taken by applying all of the presented Value-at- Risk techniques to another stock market index, the Dow Jones Industrial Average. The generous availability of historical daily return data on this index allowed us to more realistically imitate the behaviour of banks, namely by re-estimating and re-evaluating the Value-at-Risk models each year

Abstract2

CHAPTER 1: INTRODUCTION5

1.1 Introduction5

1.2 Background6

1.3 Objectives8

1.4 Research Questions9

1.5 Overview of Lusaka Stock Exchange9

1.5.1 Problem Discussion14

CHAPTER 2: THEORATICAL FRAMEWORK18

2.1 Financial Risk Management19

2.1.1 Risk Management19

2.1.2 Financial Risks20

2.1.3 Risk of Insolvency20

2.1.4 Risk of Financial Stability20

2.1.5 Inflation Risk21

2.1.6 Investment Risk21

2.1.7 Currency Risk22

2.1.8 Interest Rate Risk22

2.1.9 Deposit Risk22

2.1.10 Tax Risk23

2.1.11 Credit Risk23

2.1.12 Criminogenic Risk23

2.1.13 Structural Risk24

2.2 Financial Risks Management24

2.3 Process Financial Risk Management25

2.4 Avoiding Financial Risks26

2.4.1 Avoiding the Use of Idle Cash Assets in Short-Term Investments26

2.4.2 Avoiding Excessive Current Assets in Illiquid Forms27

2.4.3 Avoid High Debts27

2.4.4 Waiver of Financial Transactions27

2.5 Diversifying the Financial Risk27

2.5.1 Diversification of Real Investment28

2.5.2 Portfolio Diversification28

2.5.3 Diversification of Credit Portfolio28

2.5.4 Deposit Portfolio Diversification28

2.5.5 Currency Portfolio Diversification29

2.5.6 Diversification of Financial Activity29

2.6 Value-at-risk (VaR)29

EMPIRICAL STUDY: ZAMBIA'S LUSAKA STOCK EXCHANGE31

2.7 Small Economies in Sub-Saharan Africa31

2.8 The Lusaka Stock Exchange32

2.8.1 Brief history32

2.8.2 Structure33

2.9 Why Is Liquidity Low on the LuSE?35

2.9.1 Supply of stocks35

CHAPTER 3: METHODOLOGY39

3.1 Hypothesis39

3.2 Data Collection39

3.3 Variables40

3.4 GAARCH MODEL41

3.5 The Model42

?Estimation43

?Simulation43

3.6 Kupeic Test44

3.7 Christoffersen test44

3.8 Software Used45

CHAPTER 4: DATA ANALYSIS46

4.5 Review of the Lusaka stock exchange Results56

CHAPTER 5: CONCLUSION60

References63

Appendix66

CHAPTER 1: INTRODUCTION

1.1 Introduction

In this era of modernization and globalization whereby the world markets have merged together the role of the physical boundaries have decreased. With the increased globalization the transnational risks have also increased (Sellke & Renn, n.d).

The increased financial risks that have resulted due to the world economies merging among each other have increased the role requirements of the chief financial officers of the organizations around the world. The role requirements of the chief financial officers have increased from just being ordinary employees to team members of the management teams. The chief financial officers are more concerned with the long term strategic management of the organizations regarding the macroeconomic risks that the organizations are subject to. The chief financial officers are in particular concerned with formulating strategies which are consistent and overlap the organizational goals ...