Risk management of risk under the Basel Accord: A Bayesian approach to forecasting Value-at-Risk of VIX futures

It is well known that the Basel II Accord requires banks and other Authorized Deposit-taking Institutions (ADIs) to communicate their daily risk forecasts to the appropriate monetary authorities at the beginning of each trading day, using one or more risk models, whether individually or as combinations, to measure Value-at-Risk (VaR). The risk estimates of these models are used to determine capital requirements and associated capital costs of ADIs, depending in part on the number of previous violations, whereby realised losses exceed the estimated VaR. Previous papers proposed a new approach to model selection for predicting VaR, consisting of combining alternative risk models, and comparing conservative and aggressive strategies for choosing between VaR models. This paper, using Bayesian and non-Bayesian combinations of models addresses the question of risk management of risk, namely VaR of VIX futures prices, and extends the approaches given in previous papers to examine how different risk management strategies performed during the 2008–2009 global financial crisis (GFC). The use of time-varying weights using Bayesian methods, allows dynamic combinations of the different models to obtain a more accurate VaR forecasts than the estimates and forecasts that might be produced by a single model of risk. One of these dynamic combinations is endogenously determined by the pass performance in terms of daily capital charges of the individual models. This can improve the strategies to minimize daily capital charges, which is a central objective of ADIs. The empirical results suggest that an aggressive strategy of choosing the Supremum of single model forecasts, as compared with Bayesian and non-Bayesian combinations of models, is preferred to other alternatives, and is robust during the GFC.

► We analyzed strategies for managing the risk through forecasting VaR of VIX futures.
► We forecast VaR using well known univariate models and strategies based on combinations of models.
► The risk estimates are used to determine capital requirements of financial institutions.
► Time-varying weights using Bayesian methods allow dynamic combinations of risk models.
► An aggressive strategy of choosing the Supremum is robust to the Global Financial Crisis.