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Applied Quantitative Finance

Wolfgang Härdle
Torsten Kleinow
Gerhard Stahl
In cooperation with
Gökhan Aydınlı, Oliver Jim Blaskowitz, Song Xi Chen,
Matthias Fengler, Jürgen Franke, Christoph Frisch,
Helmut Herwartz, Harriet Holzberger, Steffi Höse,
Stefan Huschens, Kim Huynh, Stefan R. Jaschke, Yuze Jiang
Pierre Kervella, Rüdiger Kiesel, Germar Knöchlein,
Sven Knoth, Jens Lüssem, Danilo Mercurio,
Marlene Müller, Jörn Rank, Peter Schmidt,
Rainer Schulz, Jürgen Schumacher, Thomas Siegl,
Robert Wania, Axel Werwatz, Jun Zheng

June 20, 2002

Contents

Preface xv

Contributors xix

Frequently Used Notation xxi

I Value at Risk 1

1 Approximating Value at Risk in Conditional Gaussian Models 3

Stefan R. Jaschke and Yuze Jiang
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1.1 The Practical Need . . . . . . . . . . . . . . . . . . . . . 3
1.1.2 Statistical Modeling for VaR . . . . . . . . . . . . . . . 4
1.1.3 VaR Approximations . . . . . . . . . . . . . . . . . . . . 6
1.1.4 Pros and Cons of Delta-Gamma Approximations . . . . 7
1.2 General Properties of Delta-Gamma-Normal Models . . . . . . 8
1.3 Cornish-Fisher Approximations . . . . . . . . . . . . . . . . . . 12
1.3.1 Derivation . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.3.2 Properties . . . . . . . . . . . . . . . . . . . . . . . . . . 15
1.4 Fourier Inversion . . . . . . . . . . . . . . . . . . . . . . . . . . 16
iv Contents

1.4.1 Error Analysis . . . . . . . . . . . . . . . . . . . . . . . 16

1.4.2 Tail Behavior . . . . . . . . . . . . . . . . . . . . . . . . 20
1.4.3 Inversion of the cdf minus the Gaussian Approximation 21
1.5 Variance Reduction Techniques in Monte-Carlo Simulation . . . 24
1.5.1 Monte-Carlo Sampling Method . . . . . . . . . . . . . . 24
1.5.2 Partial Monte-Carlo with Importance Sampling . . . . . 28
1.5.3 XploRe Examples . . . . . . . . . . . . . . . . . . . . . 30

2 Applications of Copulas for the Calculation of Value-at-Risk 35

Jörn Rank and Thomas Siegl
2.1 Copulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.1.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.1.2 Sklar’s Theorem . . . . . . . . . . . . . . . . . . . . . . 37
2.1.3 Examples of Copulas . . . . . . . . . . . . . . . . . . . . 37
2.1.4 Further Important Properties of Copulas . . . . . . . . 39
2.2 Computing Value-at-Risk with Copulas . . . . . . . . . . . . . 40
2.2.1 Selecting the Marginal Distributions . . . . . . . . . . . 40
2.2.2 Selecting a Copula . . . . . . . . . . . . . . . . . . . . . 41
2.2.3 Estimating the Copula Parameters . . . . . . . . . . . . 41
2.2.4 Generating Scenarios - Monte Carlo Value-at-Risk . . . 43
2.3 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2.4 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

3 Quantification of Spread Risk by Means of Historical Simulation 51

Christoph Frisch and Germar Knöchlein
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
3.2 Risk Categories – a Definition of Terms . . . . . . . . . . . . . 51
Contents v

3.3 Descriptive Statistics of Yield Spread Time Series . . . . . . . . 53

3.3.1 Data Analysis with XploRe . . . . . . . . . . . . . . . . 54
3.3.2 Discussion of Results . . . . . . . . . . . . . . . . . . . . 58
3.4 Historical Simulation and Value at Risk . . . . . . . . . . . . . 63
3.4.1 Risk Factor: Full Yield . . . . . . . . . . . . . . . . . . . 64
3.4.2 Risk Factor: Benchmark . . . . . . . . . . . . . . . . . . 67
3.4.3 Risk Factor: Spread over Benchmark Yield . . . . . . . 68
3.4.4 Conservative Approach . . . . . . . . . . . . . . . . . . 69
3.4.5 Simultaneous Simulation . . . . . . . . . . . . . . . . . . 69
3.5 Mark-to-Model Backtesting . . . . . . . . . . . . . . . . . . . . 70
3.6 VaR Estimation and Backtesting with XploRe . . . . . . . . . . 70
3.7 P-P Plots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
3.8 Q-Q Plots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
3.9 Discussion of Simulation Results . . . . . . . . . . . . . . . . . 75
3.9.1 Risk Factor: Full Yield . . . . . . . . . . . . . . . . . . . 77
3.9.2 Risk Factor: Benchmark . . . . . . . . . . . . . . . . . . 78
3.9.3 Risk Factor: Spread over Benchmark Yield . . . . . . . 78
3.9.4 Conservative Approach . . . . . . . . . . . . . . . . . . 79
3.9.5 Simultaneous Simulation . . . . . . . . . . . . . . . . . . 80
3.10 XploRe for Internal Risk Models . . . . . . . . . . . . . . . . . 81

II Credit Risk 85

4 Rating Migrations 87
Steffi Höse, Stefan Huschens and Robert Wania
4.1 Rating Transition Probabilities . . . . . . . . . . . . . . . . . . 88
4.1.1 From Credit Events to Migration Counts . . . . . . . . 88
vi Contents

4.1.2 Estimating Rating Transition Probabilities . . . . . . . 89

4.1.3 Dependent Migrations . . . . . . . . . . . . . . . . . . . 90
4.1.4 Computation and Quantlets . . . . . . . . . . . . . . . . 93
4.2 Analyzing the Time-Stability of Transition Probabilities . . . . 94
4.2.1 Aggregation over Periods . . . . . . . . . . . . . . . . . 94
4.2.2 Are the Transition Probabilities Stationary? . . . . . . . 95
4.2.3 Computation and Quantlets . . . . . . . . . . . . . . . . 97
4.2.4 Examples with Graphical Presentation . . . . . . . . . . 98
4.3 Multi-Period Transitions . . . . . . . . . . . . . . . . . . . . . . 101
4.3.1 Time Homogeneous Markov Chain . . . . . . . . . . . . 101
4.3.2 Bootstrapping Markov Chains . . . . . . . . . . . . . . 102
4.3.3 Computation and Quantlets . . . . . . . . . . . . . . . . 104
4.3.4 Rating Transitions of German Bank Borrowers . . . . . 106
4.3.5 Portfolio Migration . . . . . . . . . . . . . . . . . . . . . 106

5 Sensitivity analysis of credit portfolio models 111

Rüdiger Kiesel and Torsten Kleinow
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
5.2 Construction of portfolio credit risk models . . . . . . . . . . . 113
5.3 Dependence modelling . . . . . . . . . . . . . . . . . . . . . . . 114
5.3.1 Factor modelling . . . . . . . . . . . . . . . . . . . . . . 115
5.3.2 Copula modelling . . . . . . . . . . . . . . . . . . . . . . 117
5.4 Simulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
5.4.1 Random sample generation . . . . . . . . . . . . . . . . 119
5.4.2 Portfolio results . . . . . . . . . . . . . . . . . . . . . . . 120
Contents vii

III Implied Volatility 125

6 The Analysis of Implied Volatilities 127

Matthias R. Fengler, Wolfgang Härdle and Peter Schmidt
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
6.2 The Implied Volatility Surface . . . . . . . . . . . . . . . . . . . 129
6.2.1 Calculating the Implied Volatility . . . . . . . . . . . . . 129
6.2.2 Surface smoothing . . . . . . . . . . . . . . . . . . . . . 131
6.3 Dynamic Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 134
6.3.1 Data description . . . . . . . . . . . . . . . . . . . . . . 134
6.3.2 PCA of ATM Implied Volatilities . . . . . . . . . . . . . 136
6.3.3 Common PCA of the Implied Volatility Surface . . . . . 137

7 How Precise Are Price Distributions Predicted by IBT? 145

Wolfgang Härdle and Jun Zheng
7.1 Implied Binomial Trees . . . . . . . . . . . . . . . . . . . . . . 146
7.1.1 The Derman and Kani (D & K) algorithm . . . . . . . . 147
7.1.2 Compensation . . . . . . . . . . . . . . . . . . . . . . . 151
7.1.3 Barle and Cakici (B & C) algorithm . . . . . . . . . . . 153
7.2 A Simulation and a Comparison of the SPDs . . . . . . . . . . 154
7.2.1 Simulation using Derman and Kani algorithm . . . . . . 154
7.2.2 Simulation using Barle and Cakici algorithm . . . . . . 156
7.2.3 Comparison with Monte-Carlo Simulation . . . . . . . . 158
7.3 Example – Analysis of DAX data . . . . . . . . . . . . . . . . . 162

8 Estimating State-Price Densities with Nonparametric Regression 171

Kim Huynh, Pierre Kervella and Jun Zheng
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
viii Contents

8.2 Extracting the SPD using Call-Options . . . . . . . . . . . . . 173

8.2.1 Black-Scholes SPD . . . . . . . . . . . . . . . . . . . . . 175
8.3 Semiparametric estimation of the SPD . . . . . . . . . . . . . . 176
8.3.1 Estimating the call pricing function . . . . . . . . . . . 176
8.3.2 Further dimension reduction . . . . . . . . . . . . . . . 177
8.3.3 Local Polynomial Estimation . . . . . . . . . . . . . . . 181
8.4 An Example: Application to DAX data . . . . . . . . . . . . . 183
8.4.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
8.4.2 SPD, delta and gamma . . . . . . . . . . . . . . . . . . 185
8.4.3 Bootstrap confidence bands . . . . . . . . . . . . . . . . 187
8.4.4 Comparison to Implied Binomial Trees . . . . . . . . . . 190

9 Trading on Deviations of Implied and Historical Densities 197

Oliver Jim Blaskowitz and Peter Schmidt
9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
9.2 Estimation of the Option Implied SPD . . . . . . . . . . . . . . 198
9.2.1 Application to DAX Data . . . . . . . . . . . . . . . . . 198
9.3 Estimation of the Historical SPD . . . . . . . . . . . . . . . . . 200
9.3.1 The Estimation Method . . . . . . . . . . . . . . . . . . 201
9.3.2 Application to DAX Data . . . . . . . . . . . . . . . . . 202
9.4 Comparison of Implied and Historical SPD . . . . . . . . . . . 205
9.5 Skewness Trades . . . . . . . . . . . . . . . . . . . . . . . . . . 207
9.5.1 Performance . . . . . . . . . . . . . . . . . . . . . . . . 210
9.6 Kurtosis Trades . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
9.6.1 Performance . . . . . . . . . . . . . . . . . . . . . . . . 214
9.7 A Word of Caution . . . . . . . . . . . . . . . . . . . . . . . . . 216
Contents ix

IV Econometrics 219

10 Multivariate Volatility Models 221

Matthias R. Fengler and Helmut Herwartz
10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
10.1.1 Model specifications . . . . . . . . . . . . . . . . . . . . 222
10.1.2 Estimation of the BEKK-model . . . . . . . . . . . . . . 224
10.2 An empirical illustration . . . . . . . . . . . . . . . . . . . . . . 225
10.2.1 Data description . . . . . . . . . . . . . . . . . . . . . . 225
10.2.2 Estimating bivariate GARCH . . . . . . . . . . . . . . . 226
10.2.3 Estimating the (co)variance processes . . . . . . . . . . 229
10.3 Forecasting exchange rate densities . . . . . . . . . . . . . . . . 232

11 Statistical Process Control 237

Sven Knoth
11.1 Control Charts . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
11.2 Chart characteristics . . . . . . . . . . . . . . . . . . . . . . . . 243
11.2.1 Average Run Length and Critical Values . . . . . . . . . 247
11.2.2 Average Delay . . . . . . . . . . . . . . . . . . . . . . . 248
11.2.3 Probability Mass and Cumulative Distribution Function 248
11.3 Comparison with existing methods . . . . . . . . . . . . . . . . 251
11.3.1 Two-sided EWMA and Lucas/Saccucci . . . . . . . . . 251
11.3.2 Two-sided CUSUM and Crosier . . . . . . . . . . . . . . 251
11.4 Real data example – monitoring CAPM . . . . . . . . . . . . . 253

12 An Empirical Likelihood Goodness-of-Fit Test for Diffusions 259

Song Xi Chen, Wolfgang Härdle and Torsten Kleinow
12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
x Contents

12.2 Discrete Time Approximation of a Diffusion . . . . . . . . . . . 260

12.3 Hypothesis Testing . . . . . . . . . . . . . . . . . . . . . . . . . 261
12.4 Kernel Estimator . . . . . . . . . . . . . . . . . . . . . . . . . . 263
12.5 The Empirical Likelihood concept . . . . . . . . . . . . . . . . . 264
12.5.1 Introduction into Empirical Likelihood . . . . . . . . . . 264
12.5.2 Empirical Likelihood for Time Series Data . . . . . . . . 265
12.6 Goodness-of-Fit Statistic . . . . . . . . . . . . . . . . . . . . . . 268
12.7 Goodness-of-Fit test . . . . . . . . . . . . . . . . . . . . . . . . 272
12.8 Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
12.9 Simulation Study and Illustration . . . . . . . . . . . . . . . . . 276
12.10Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279

13 A simple state space model of house prices 283

Rainer Schulz and Axel Werwatz
13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
13.2 A Statistical Model of House Prices . . . . . . . . . . . . . . . . 284
13.2.1 The Price Function . . . . . . . . . . . . . . . . . . . . . 284
13.2.2 State Space Form . . . . . . . . . . . . . . . . . . . . . . 285
13.3 Estimation with Kalman Filter Techniques . . . . . . . . . . . 286
13.3.1 Kalman Filtering given all parameters . . . . . . . . . . 286
13.3.2 Filtering and state smoothing . . . . . . . . . . . . . . . 287
13.3.3 Maximum likelihood estimation of the parameters . . . 288
13.3.4 Diagnostic checking . . . . . . . . . . . . . . . . . . . . 289
13.4 The Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
13.5 Estimating and filtering in XploRe . . . . . . . . . . . . . . . . 293
13.5.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . 293
13.5.2 Setting the system matrices . . . . . . . . . . . . . . . . 293
Contents xi

13.5.3 Kalman filter and maximized log likelihood . . . . . . . 295

13.5.4 Diagnostic checking with standardized residuals . . . . . 298
13.5.5 Calculating the Kalman smoother . . . . . . . . . . . . 300
13.6 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
13.6.1 Procedure equivalence . . . . . . . . . . . . . . . . . . . 302
13.6.2 Smoothed constant state variables . . . . . . . . . . . . 304

14 Long Memory Effects Trading Strategy 309

Oliver Jim Blaskowitz and Peter Schmidt
14.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
14.2 Hurst and Rescaled Range Analysis . . . . . . . . . . . . . . . . 310
14.3 Stationary Long Memory Processes . . . . . . . . . . . . . . . . 312
14.3.1 Fractional Brownian Motion and Noise . . . . . . . . . . 313
14.4 Data Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
14.5 Trading the Negative Persistence . . . . . . . . . . . . . . . . . 318

15 Locally time homogeneous time series modeling 323

Danilo Mercurio
15.1 Intervals of homogeneity . . . . . . . . . . . . . . . . . . . . . . 323
15.1.1 The adaptive estimator . . . . . . . . . . . . . . . . . . 326
15.1.2 A small simulation study . . . . . . . . . . . . . . . . . 327
15.2 Estimating the coefficients of an exchange rate basket . . . . . 329
15.2.1 The Thai Baht basket . . . . . . . . . . . . . . . . . . . 331
15.2.2 Estimation results . . . . . . . . . . . . . . . . . . . . . 335
15.3 Estimating the volatility of financial time series . . . . . . . . . 338
15.3.1 The standard approach . . . . . . . . . . . . . . . . . . 339
15.3.2 The locally time homogeneous approach . . . . . . . . . 340
xii Contents

15.3.3 Modeling volatility via power transformation . . . . . . 340

15.3.4 Adaptive estimation under local time-homogeneity . . . 341
15.4 Technical appendix . . . . . . . . . . . . . . . . . . . . . . . . . 344

16 Simulation based Option Pricing 349

Jens Lüssem and Jürgen Schumacher
16.1 Simulation techniques for option pricing . . . . . . . . . . . . . 349
16.1.1 Introduction to simulation techniques . . . . . . . . . . 349
16.1.2 Pricing path independent European options on one un-
derlying . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
16.1.3 Pricing path dependent European options on one under-
lying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
16.1.4 Pricing options on multiple underlyings . . . . . . . . . 355
16.2 Quasi Monte Carlo (QMC) techniques for option pricing . . . . 356
16.2.1 Introduction to Quasi Monte Carlo techniques . . . . . 356
16.2.2 Error bounds . . . . . . . . . . . . . . . . . . . . . . . . 356
16.2.3 Construction of the Halton sequence . . . . . . . . . . . 357
16.2.4 Experimental results . . . . . . . . . . . . . . . . . . . . 359
16.3 Pricing options with simulation techniques - a guideline . . . . 361
16.3.1 Construction of the payoff function . . . . . . . . . . . . 362
16.3.2 Integration of the payoff function in the simulation frame-
work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
16.3.3 Restrictions for the payoff functions . . . . . . . . . . . 365

17 Nonparametric Estimators of GARCH Processes 367

Jürgen Franke, Harriet Holzberger and Marlene Müller
17.1 Deconvolution density and regression estimates . . . . . . . . . 369
17.2 Nonparametric ARMA Estimates . . . . . . . . . . . . . . . . . 370
Contents xiii

17.3 Nonparametric GARCH Estimates . . . . . . . . . . . . . . . . 379

18 Net Based Spreadsheets in Quantitative Finance 385

Gökhan Aydınlı
18.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
18.2 Client/Server based Statistical Computing . . . . . . . . . . . . 386
18.3 Why Spreadsheets? . . . . . . . . . . . . . . . . . . . . . . . . . 387
18.4 Using MD*ReX . . . . . . . . . . . . . . . . . . . . . . . . . . . 388
18.5 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
18.5.1 Value at Risk Calculations with Copulas . . . . . . . . . 391
18.5.2 Implied Volatility Measures . . . . . . . . . . . . . . . . 393

Index 398
Preface

This book is designed for students and researchers who want to develop pro-
fessional skill in modern quantitative applications in finance. The Center for
Applied Statistics and Economics (CASE) course at Humboldt-Universität zu
Berlin that forms the basis for this book is offered to interested students who
have had some experience with probability, statistics and software applications
but have not had advanced courses in mathematical finance. Although the
course assumes only a modest background it moves quickly between different
fields of applications and in the end, the reader can expect to have theoretical
and computational tools that are deep enough and rich enough to be relied on
throughout future professional careers.
The text is readable for the graduate student in financial engineering as well as
for the inexperienced newcomer to quantitative finance who wants to get a grip
on modern statistical tools in financial data analysis. The experienced reader
with a bright knowledge of mathematical finance will probably skip some sec-
tions but will hopefully enjoy the various computational tools of the presented
techniques. A graduate student might think that some of the econometric
techniques are well known. The mathematics of risk management and volatil-
ity dynamics will certainly introduce him into the rich realm of quantitative
financial data analysis.
The computer inexperienced user of this e-book is softly introduced into the
interactive book concept and will certainly enjoy the various practical exam-
ples. The e-book is designed as an interactive document: a stream of text and
information with various hints and links to additional tools and features. Our
e-book design offers also a complete PDF and HTML file with links to world
wide computing servers. The reader of this book may therefore without down-
load or purchase of software use all the presented examples and methods via
the enclosed license code number with a local XploRe Quantlet Server (XQS).
Such XQ Servers may also be installed in a department or addressed freely on
the web, click to www.xplore-stat.de and www.quantlet.com.
xvi Preface

”Applied Quantitative Finance” consists of four main parts: Value at Risk,

Credit Risk, Implied Volatility and Econometrics. In the first part Jaschke and
Jiang treat the Approximation of the Value at Risk in conditional Gaussian
Models and Rank and Siegl show how the VaR can be calculated using copulas.
The second part starts with an analysis of rating migration probabilities by
Höse, Huschens and Wania. Frisch and Knöchlein quantify the risk of yield
spread changes via historical simulations. This part is completed by an anal-
ysis of the sensitivity of risk measures to changes in the dependency structure
between single positions of a portfolio by Kiesel and Kleinow.
The third part is devoted to the analysis of implied volatilities and their dynam-
ics. Fengler, Härdle and Schmidt start with an analysis of the implied volatility
surface and show how common PCA can be applied to model the dynamics of
the surface. In the next two chapters the authors estimate the risk neutral
state price density from observed option prices and the corresponding implied
volatilities. While Härdle and Zheng apply implied binomial trees to estimate
the SPD, the method by Huynh, Kervella and Zheng is based on a local poly-
nomial estimation of the implied volatility and its derivatives. Blaskowitz and
Schmidt use the proposed methods to develop trading strategies based on the
comparison of the historical SPD and the one implied by option prices.
Recently developed econometric methods are presented in the last part of the
book. Fengler and Herwartz introduce a multivariate volatility model and ap-
ply it to exchange rates. Methods used to monitor sequentially observed data
are treated by Knoth. Chen, Härdle and Kleinow apply the empirical likeli-
hood concept to develop a test about a parametric diffusion model. Schulz
and Werwatz estimate a state space model of Berlin house prices that can be
used to construct a time series of the price of a standard house. The influ-
ence of long memory effects on financial time series is analyzed by Blaskowitz
and Schmidt. Mercurio propose a methodology to identify time intervals of
homogeneity for time series. The pricing of exotic options via a simulation
approach is introduced by Lüssem and Schumacher The chapter by Franke,
Holzberger and Müller is devoted to a nonparametric estimation approach of
GARCH models. The book closes with a chapter of Aydınlı, who introduces
a technology to connect standard software with the XploRe server in order to
have access to quantlets developed in this book.
We gratefully acknowledge the support of Deutsche Forschungsgemeinschaft,
SFB 373 Quantifikation und Simulation Ökonomischer Prozesse. A book of this
kind would not have been possible without the help of many friends, colleagues
and students. For the technical production of the e-book platform we would
Preface xvii

like to thank Jörg Feuerhake, Zdeněk Hlávka, Sigbert Klinke, Heiko Lehmann
and Rodrigo Witzel.
W. Härdle, T. Kleinow and G. Stahl
Berlin and Bonn, June 2002
Contributors

Gökhan Aydınlı Humboldt-Universität zu Berlin, CASE, Center for Applied

Statistics and Economics
Oliver Jim Blaskowitz Humboldt-Universität zu Berlin, CASE, Center for Ap-
plied Statistics and Economics
Song Xi Chen The National University of Singapore, Dept. of Statistics and
Applied Probability
Matthias R. Fengler Humboldt-Universität zu Berlin, CASE, Center for Ap-
plied Statistics and Economics
Jürgen Franke Universität Kaiserslautern
Christoph Frisch Landesbank Rheinland-Pfalz, Risikoüberwachung
Wolfgang Härdle Humboldt-Universität zu Berlin, CASE, Center for Applied
Statistics and Economics
Helmut Herwartz Humboldt-Universität zu Berlin, CASE, Center for Applied
Statistics and Economics
Harriet Holzberger IKB Deutsche Industriebank AG
Steffi Höse Technische Universität Dresden

Stefan Huschens Technische Universität Dresden

Kim Huynh Queen’s Economics Department, Queen’s University
Stefan R. Jaschke Weierstrass Institute for Applied Analysis and Stochastics
Yuze Jiang Queen’s School of Business, Queen’s University
xx Contributors

Pierre Kervella Humboldt-Universität zu Berlin, CASE, Center for Applied

Statistics and Economics
Rüdiger Kiesel London School of Economics, Department of Statistics
Torsten Kleinow Humboldt-Universität zu Berlin, CASE, Center for Applied
Statistics and Economics
Germar Knöchlein Landesbank Rheinland-Pfalz, Risikoüberwachung
Sven Knoth European University Viadrina Frankfurt (Oder)
Jens Lüssem Landesbank Kiel
Danilo Mercurio Humboldt-Universität zu Berlin, CASE, Center for Applied
Statistics and Economics
Marlene Müller Humboldt-Universität zu Berlin, CASE, Center for Applied
Statistics and Economics
Jörn Rank Andersen, Financial and Commodity Risk Consulting
Peter Schmidt Humboldt-Universität zu Berlin, CASE, Center for Applied
Statistics and Economics
Rainer Schulz Humboldt-Universität zu Berlin, CASE, Center for Applied Statis-
tics and Economics
Jürgen Schumacher University of Bonn, Department of Computer Science
Thomas Siegl BHF Bank
Robert Wania Technische Universität Dresden
Axel Werwatz Humboldt-Universität zu Berlin, CASE, Center for Applied
Statistics and Economics
Jun Zheng Department of Probability and Statistics, School of Mathematical
Sciences, Peking University, 100871, Beijing, P.R. China
Frequently Used Notation

def
x = . . . x is defined as ...
R real numbers
def
R = R ∪ {∞, ∞}
A> transpose of matrix A
X ∼ D the random variable X has distribution D
E[X] expected value of random variable X
Var(X) variance of random variable X
Std(X) standard deviation of random variable X
Cov(X, Y ) covariance of two random variables X and Y
N(µ, Σ) normal distribution with expectation µ and covariance matrix Σ, a
similar notation is used if Σ is the correlation matrix
cdf denotes the cumulative distribution function
pdf denotes the probability density function
P[A] or P(A) probability of a set A
1 indicator function
def
(F ◦ G)(x) = F {G(x)} for functions F and G
αn = O(βn ) iff αβnn −→ constant, as n −→ ∞
αn = O(βn ) iff αβnn −→ 0, as n −→ ∞
Ft is the information set generated by all information available at time t

Let An and Bn be sequences of random variables.

An = Op (Bn ) iff ∀ε > 0 ∃M, ∃N such that P[|An /Bn | > M ] < ε, ∀n > N .
An = Op (Bn ) iff ∀ε > 0 : limn→∞ P[|An /Bn | > ε] = 0.
 Part I

Value at Risk
1 Approximating Value at Risk in
Conditional Gaussian Models
Stefan R. Jaschke and Yuze Jiang

1.1 Introduction

1.1.1 The Practical Need

Financial institutions are facing the important task of estimating and control-
ling their exposure to market risk, which is caused by changes in prices of
equities, commodities, exchange rates and interest rates. A new chapter of risk
management was opened when the Basel Committee on Banking Supervision
proposed that banks may use internal models for estimating their market risk
(Basel Committee on Banking Supervision, 1995). Its implementation into na-
tional laws around 1998 allowed banks to not only compete in the innovation
of financial products but also in the innovation of risk management methodol-
ogy. Measurement of market risk has focused on a metric called Value at Risk
(VaR). VaR quantifies the maximal amount that may be lost in a portfolio over
a given period of time, at a certain confidence level. Statistically speaking, the
VaR of a portfolio is the quantile of the distribution of that portfolio’s loss over
a specified time interval, at a given probability level.

The implementation of a firm-wide risk management system is a tremendous

job. The biggest challenge for many institutions is to implement interfaces to
all the different front-office systems, back-office systems and databases (poten-
tially running on different operating systems and being distributed all over the
world), in order to get the portfolio positions and historical market data into a
centralized risk management framework. This is a software engineering prob-
lem. The second challenge is to use the computed VaR numbers to actually
4 1 Approximating Value at Risk in Conditional Gaussian Models

control risk and to build an atmosphere where the risk management system
is accepted by all participants. This is an organizational and social problem.
The methodological question how risk should be modeled and approximated
is – in terms of the cost of implementation – a smaller one. In terms of im-
portance, however, it is a crucial question. A non-adequate VaR-methodology
can jeopardize all the other efforts to build a risk management system. See
(Jorion, 2000) for more on the general aspects of risk management in financial
institutions.

1.1.2 Statistical Modeling for VaR

VaR methodologies can be classified in terms of statistical modeling decisions

and approximation decisions. Once the statistical model and the estimation
procedure is specified, it is a purely numerical problem to compute or approx-
imate the Value at Risk. The modeling decisions are:

1. Which risk factors to include. This mainly depends on a banks’ business

(portfolio). But it may also depend on the availability of historical data.
If data for a certain contract is not available or the quality is not sufficient,
a related risk factor with better historical data may be used. For smaller
stock portfolios it is customary to include each stock itself as a risk factor.
For larger stock portfolios, only country or sector indexes are taken as
the risk factors (Longerstaey, 1996). Bonds and interest rate derivatives
are commonly assumed to depend on a fixed set of interest rates at key
maturities. The value of options is usually assumed to depend on implied
volatility (at certain key strikes and maturities) as well as on everything
the underlying depends on.
2. How to model security prices as functions of risk factors, which is usually
called “the mapping”. If Xti denotes the log return of stock i over the
time interval [t − 1, t], i.e., Xti = log(Sti ) − log(St−1
i
), then the change in
the value of a portfolio containing one stock i is
i
∆Sti = St−1
i
(eXt − 1),

where Sti denotes the price of stock i at time t. Bonds are first decomposed
into a portfolio of zero bonds. Zero bonds are assumed to depend on
the two key interest rates with the closest maturities. How to do the
interpolation is actually not as trivial as it may seem, as demonstrated
1.1 Introduction 5

by Mina and Ulmer (1999). Similar issues arise in the interpolation of

implied volatilities.
3. What stochastic properties to assume for the dynamics of the risk factors
Xt . The basic benchmark model for stocks is to assume that logarith-
mic stock returns are joint normal (cross-sectionally) and independent in
time. Similar assumptions for other risk factors are that changes in the
logarithm of zero-bond yields, changes in log exchange rates, and changes
in the logarithm of implied volatilities are all independent in time and
joint normally distributed.
4. How to estimate the model parameters from the historical data. The usual
statistical approach is to define the model and then look for estimators
that have certain optimality criteria. In the basic benchmark model the
minimal-variance unbiased estimator of the covariance matrix Σ of risk
factors Xt is the “rectangular moving average”
T
1 X
Σ̂ = (Xt − µ)(Xt − µ)>
T − 1 t=1

def
(with µ = E[Xt ]). An alternative route is to first specify an estimator
and then look for a model in which that estimator has certain optimality
properties. The exponential moving average
T
X −1
Σ̂T = (eλ − 1) e−λ(T −t) (Xt − µ)(Xt − µ)>
t=−∞

can be interpreted as an efficient estimator of the conditional covariance

matrix ΣT of the vector of risk factors XT , given the information up to
time T − 1 in a very specific GARCH model.

While there is a plethora of analyses of alternative statistical models for market

risks (see Barry Schachter’s Gloriamundi web site), mainly two classes of models
for market risk have been used in practice:

1. iid-models, i.e., the risk factors Xt are assumed to be independent in time,

but the distribution of Xt is not necessarily Gaussian. Apart from some
less common models involving hyperbolic distributions (Breckling, Eber-
lein and Kokic, 2000), most approaches either estimate the distribution
6 1 Approximating Value at Risk in Conditional Gaussian Models

of Xt completely non-parametrically and run under the name “histori-

cal simulation”, or they estimate the tail using generalized Pareto dis-
tributions (Embrechts, Klüppelberg and Mikosch, 1997, “extreme value
theory”).
2. conditional Gaussian models, i.e., the risk factors Xt are assumed to be
joint normal, conditional on the information up to time t − 1.

Both model classes can account for unconditional “fat tails”.

1.1.3 VaR Approximations

In this paper we consider certain approximations of VaR in the conditional

Gaussian class of models. We assume that the conditional expectation of Xt ,
µt , is zero and its conditional covariance matrix Σt is estimated and given at
time t − 1. The change in the portfolio value over the time interval [t − 1, t] is
then
n
X
∆Vt (Xt ) = wi ∆Sti (Xt ),
i=1
where the wi are the portfolio weights and ∆Sti is the function that “maps” the
risk factor vector Xt to a change in the value of the i-th security value over the
time interval [t − 1, t], given all the information at time t − 1. These functions
are usually nonlinear, even for stocks (see above). In the following, we will
drop the time index and denote by ∆V the change in the portfolio’s value over
the next time interval and by X the corresponding vector of risk factors.
The only general method to compute quantiles of the distribution of ∆V is
Monte Carlo simulation. From discussion with practitioners “full valuation
Monte Carlo” appears to be practically infeasible for portfolios with securi-
ties whose mapping functions are first, extremely costly to compute – like for
certain path-dependent options whose valuation itself relies on Monte-Carlo
simulation – and second, computed inside complex closed-source front-office
systems, which cannot be easily substituted or adapted in their accuracy/speed
trade-offs. Quadratic approximations to the portfolio’s value as a function of
the risk factors
1
∆V (X) ≈ ∆> X + X > ΓX, (1.1)
2
have become the industry standard since its use in RiskMetrics (Longerstaey,
1996). (∆ and Γ are the aggregated first and second derivatives of the indi-
vidual mapping functions ∆S i w.r.t. the risk factors X. The first version of
1.1 Introduction 7

RiskMetrics in 1994 considered only the first derivative of the value function,
the “delta”. Without loss of generality, we assume that the constant term in
the Taylor expansion (1.1), the “theta”, is zero.)

1.1.4 Pros and Cons of Delta-Gamma Approximations

Both assumptions of the Delta-Gamma-Normal approach – Gaussian innova-

tions and a reasonably good quadratic approximation of the value function V
– have been questioned. Simple examples of portfolios with options can be
constructed to show that quadratic approximations to the value function can
lead to very large errors in the computation of VaR (Britton-Jones and Schae-
fer, 1999). The Taylor-approximation (1.1) holds only locally and is question-
able from the outset for the purpose of modeling extreme events. Moreover,
the conditional Gaussian framework does not allow to model joint extremal
events, as described by Embrechts, McNeil and Straumann (1999). The Gaus-
sian dependence structure, the copula, assigns too small probabilities to joint
extremal events compared to some empirical observations.
Despite these valid critiques of the Delta-Gamma-Normal model, there are good
reasons for banks to implement it alongside other models. (1) The statistical
assumption of conditional Gaussian risk factors can explain a wide range of
“stylized facts” about asset returns like unconditional fat tails and autocor-
relation in realized volatility. Parsimonious multivariate conditional Gaussian
models for dimensions like 500-2000 are challenging enough to be the subject of
ongoing statistical research, Engle (2000). (2) First and second derivatives of
financial products w.r.t. underlying market variables (= deltas and gammas)
and other “sensitivities” are widely implemented in front office systems and
routinely used by traders. Derivatives w.r.t. possibly different risk factors used
by central risk management are easily computed by applying the chain rule
of differentiation. So it is tempting to stay in the framework and language of
the trading desks and express portfolio value changes in terms of deltas and
gammas. (3) For many actual portfolios the delta-gamma approximation may
serve as a good control-variate within variance-reduced Monte-Carlo methods,
if it is not a sufficiently good approximation itself. Finally (4), is it extremely
risky for a senior risk manager to ignore delta-gamma models if his friendly
consultant tells him that 99% of the competitors have it implemented.
Several methods have been proposed to compute a quantile of the distribution
defined by the model (1.1), among them Monte Carlo simulation (Pritsker,
1996), Johnson transformations (Zangari, 1996a; Longerstaey, 1996), Cornish-
8 1 Approximating Value at Risk in Conditional Gaussian Models

Fisher expansions (Zangari, 1996b; Fallon, 1996), the Solomon-Stephens ap-

proximation (Britton-Jones and Schaefer, 1999), moment-based approxima-
tions motivated by the theory of estimating functions (Li, 1999), saddle-point
approximations (Rogers and Zane, 1999), and Fourier-inversion (Rouvinez,
1997; Albanese, Jackson and Wiberg, 2000). Pichler and Selitsch (1999) com-
pare five different VaR-methods: Johnson transformations, Delta-Normal, and
Cornish-Fisher-approximations up to the second, fourth and sixth moment.
The sixth-order Cornish-Fisher-approximation compares well against the other
techniques and is the final recommendation. Mina and Ulmer (1999) also com-
pare Johnson transformations, Fourier inversion, Cornish-Fisher approxima-
tions, and partial Monte Carlo. (If the true value function ∆V (X) in Monte
Carlo simulation is used, this is called “full Monte Carlo”. If its quadratic ap-
proximation is used, this is called “partial Monte Carlo”.) Johnson transforma-
tions are concluded to be “not a robust choice”. Cornish-Fisher is “extremely
fast” compared to partial Monte Carlo and Fourier inversion, but not as robust,
as it gives “unacceptable results” in one of the four sample portfolios.
The main three methods used in practice seem to be Cornish-Fisher expansions,
Fourier inversion, and partial Monte Carlo, whose implementation in XploRe
will be presented in this paper. What makes the Normal-Delta-Gamma model
especially tractable is that the characteristic function of the probability distri-
bution, i.e. the Fourier transform of the probability density, of the quadratic
form (1.1) is known analytically. Such general properties are presented in sec-
tion 1.2. Sections 1.3, 1.4, and 1.5 discuss the Cornish-Fisher, Fourier inversion,
and partial Monte Carlo techniques, respectively.

1.2 General Properties of Delta-Gamma-Normal

Models
The change in the portfolio value, ∆V , can be expressed as a sum of indepen-
dent random variables that are quadratic functions of standard normal random
variables Yi by means of the solution of the generalized eigenvalue problem

CC > = Σ,
C > ΓC = Λ.
1.2 General Properties of Delta-Gamma-Normal Models 9

This implies
m
X 1
∆V = (δi Yi + λi Yi2 ) (1.2)
i=1
2
m
( 2 )
δi2

X 1 δi
= λi + Yi −
i=1
2 λi 2λi

with X = CY , δ = C > ∆ and Λ = diag(λ1 , . . . , λm ). Packages like LAPACK

(Anderson, Bai, Bischof, Blackford, Demmel, Dongarra, Croz, Greenbaum,
Hammarling, McKenney and Sorensen, 1999) contain routines directly for the
generalized eigenvalue problem. Otherwise C and Λ can be computed in two
steps:

1. Compute some matrix B with BB > = Σ. If Σ is positive definite, the

fastest method is Cholesky decomposition. Otherwise an eigenvalue de-
composition can be used.
2. Solve the (standard) symmetric eigenvalue problem for the matrix B > ΓB:
Q> B > ΓBQ = Λ
def
with Q−1 = Q> and set C = BQ.

The decomposition is implemented in the quantlet

npar= VaRDGdecomp(par)
uses a generalized eigen value decomposition to do a suitable co-
ordinate change. par is a list containing Delta, Gamma, Sigma on
input. npar is the same list, containing additionally B, delta,
and lambda on output.

The characteristic function of a non-central χ21 variate ((Z + a)2 , with standard
normal Z) is known analytically:
 2 
it(Z+a)2 −1/2 a it
Ee = (1 − 2it) exp .
1 − 2it
This implies the characteristic function for ∆V
Y 1 1
Eeit∆V = √ exp{− δj2 t2 /(1 − iλj t)}, (1.3)
j
1 − iλ j t 2
10 1 Approximating Value at Risk in Conditional Gaussian Models

which can be re-expressed in terms of Γ and B

1
Eeit∆V = det(I − itB > ΓB)−1/2 exp{− t2 ∆> B(I − itB > ΓB)−1 B > ∆}, (1.4)
2
or in terms of Γ and Σ
1
Eeit∆V = det(I − itΓΣ)−1/2 exp{− t2 ∆> Σ(I − itΓΣ)−1 ∆}. (1.5)
2

Numerical Fourier-inversion of (1.3) can be used to compute an approximation

to the cumulative distribution function (cdf) F of ∆V . (The α-quantile is
computed by root-finding in F (x) = α.) The cost of the Fourier-inversion is
O(N log N ), the cost of the function evaluations is O(mN ), and the cost of the
eigenvalue decomposition is O(m3 ). The cost of the eigenvalue decomposition
dominates the other two terms for accuracies of one or two decimal digits and
the usual number of risk factors of more than a hundred. Instead of a full
spectral decomposition, one can also just reduce B > ΓB to tridiagonal form
B > ΓB = QT Q> . (T is tridiagonal and Q is orthogonal.) Then the evaluation
of the characteristic function in (1.4) involves the solution of a linear system
with the matrix I −itT , which costs only O(m) operations. An alternative route
is to reduce ΓΣ to Hessenberg form ΓΣ = QHQ> or do a Schur decomposition
ΓΣ = QRQ> . (H is Hessenberg and Q is orthogonal. Since ΓΣ has the same
eigenvalues as B > ΓB and they are all real, R is actually triangular instead of
quasi-triangular in the general case, Anderson et al. (1999). The evaluation of
(1.5) becomes O(m2 ), since it involves the solution of a linear system with the
matrix I − itH or I − itR, respectively. Reduction to tridiagonal, Hessenberg,
or Schur form is also O(m3 ), so the asymptotics in the number of risk factors
m remain the same in all cases. The critical N , above which the complete
spectral decomposition + fast evaluation via (1.3) is faster than the reduction
to tridiagonal or Hessenberg form + slower evaluation via (1.4) or (1.5) remains
to be determined empirically for given m on a specific machine.
The computation of the cumulant generating function and the characteristic
function from the diagonalized form is implemented in the following quantlets:
1.2 General Properties of Delta-Gamma-Normal Models 11

z= VaRcgfDG(t,par)
Computes the cumulant generating function (cgf) for the class of
quadratic forms of Gaussian vectors.
z= VaRcharfDG(t,par)
Computes the characteristic function for the class of quadratic
forms of Gaussian vectors.

t is the complex argument and par the parameter list generated by

VaRDGdecomp.
The advantage of the Cornish-Fisher approximation is that it is based on the
cumulants, which can be computed without any matrix decomposition:
1X 1
κ1 = λi = tr(ΓΣ),
2 i 2
1X 1
κr = {(r − 1)!λri + r!δi2 λr−2
i }= (r − 1)! tr((ΓΣ)r )
2 i 2
1
+ r!∆> Σ(ΓΣ)r−2 ∆
2
(r ≥ 2). Although the cost of computing the cumulants needed for the Cornish-
Fisher approximation is also O(m3 ), this method can be faster than the eigen-
value decomposition for small orders of approximation and relatively small
numbers of risk factors.
The computation of all cumulants up to a certain order directly from ΓΣ is im-
plemented in the quantlet VaRcumulantsDG, while the computation of a single
cumulant from the diagonal decomposition is provided by VaRcumulantDG:

vec= VaRcumulantsDG(n,par)
Computes the first n cumulants for the class of quadratic forms
of Gaussian vectors. The list par contains at least Gamma and
Sigma.

z= VaRcumulantDG(n,par)
Computes the n-th cumulant for the class of quadratic forms of
Gaussian vectors. The parameter list par is to be generated with
VaRDGdecomp.
12 1 Approximating Value at Risk in Conditional Gaussian Models

Partial Monte-Carlo (or partial Quasi-Monte-Carlo) costs O(m2 ) operations

per sample. (If Γ is sparse, it may cost even less.) The number of samples
needed is a function of the desired accuracy. It is clear from the asymptotic
costs of the three methods that partial Monte Carlo will be preferable for
sufficiently large m.
While Fourier-inversion and Partial Monte-Carlo can in principal achieve any
desired accuracy, the Cornish-Fisher approximations provide only a limited
accuracy, as shown in the next section.

1.3 Cornish-Fisher Approximations

1.3.1 Derivation

The Cornish-Fisher expansion can be derived in two steps. Let Φ denote some
base distribution and φ its density function. The generalized Cornish-Fisher
expansion (Hill and Davis, 1968) aims to approximate an α-quantile of F in
terms of the α-quantile of Φ, i.e., the concatenated function F −1 ◦ Φ. The key
to a series expansion of F −1 ◦Φ in terms of derivatives of F and Φ is Lagrange’s
inversion theorem. It states that if a function s 7→ t is implicitly defined by
t = c + s · h(t) (1.6)
and h is analytic in c, then an analytic function f (t) can be developed into a
power series in a neighborhood of s = 0 (t = c):
∞
X sr
f (t) = f (c) + Dr−1 [f 0 · hr ](c), (1.7)
r=1
r!

where D denotes the differentation operator. For a given probability c = α,

f = Φ−1 , and h = (Φ − F ) ◦ Φ−1 this yields
∞
X sr r−1
Φ−1 (t) = Φ−1 (α) + (−1)r D [((F − Φ)r /φ) ◦ Φ−1 ](α). (1.8)
r=1
r!

Setting s = 1 in (1.6) implies Φ−1 (t) = F −1 (α) and with the notations x =
F −1 (α), z = Φ−1 (α) (1.8) becomes the formal expansion
∞
X 1 r−1
x=z+ (−1)r D [((F − Φ)r /φ) ◦ Φ−1 ](Φ(z)).
r=1
r!
1.3 Cornish-Fisher Approximations 13

With a = (F − Φ)/φ this can be written as

∞
X 1
x=z+ (−1)r D(r−1) [ar ](z) (1.9)
r=1
r!
0 0 0
with D(r) = (D+ φφ )(D+2 φφ ) . . . (D+r φφ ) and D(0) being the identity operator.
(1.9) is the generalized Cornish-Fisher expansion. The second step is to choose a
specific base distribution Φ and a series expansion for a. The classical Cornish-
Fisher expansion is recovered if Φ is the standard normal distribution, a is
(formally) expanded into the Gram-Charlier series, and the terms are re-ordered
as described below.
The idea of the Gram-Charlier series is to develop the ratio of the moment
generating function of the considered random variable (M (t) = Eet∆V ) and
2
the moment generating function of the standard normal distribution (et /2 )
into a power series at 0:
∞
−t2 /2
X
M (t)e = ck tk . (1.10)
k=0

(ck are the Gram-Charlier coefficients. They can be derived from the moments
by multiplying the power series for the two terms on the left hand side.) Com-
ponentwise Fourier inversion yields the corresponding series for the probability
density
X∞
f (x) = ck (−1)k φ(k) (x) (1.11)
k=0
and for the cumulative distribution function (cdf)
∞
X
F (x) = Φ(x) − ck (−1)k−1 φ(k−1) (x). (1.12)
k=1

(φ und Φ are now the standard normal density and cdf. The derivatives of
the standard normal density are (−1)k φ(k) (x) = φ(x)Hk (x), where the Her-
mite polynomials Hk form an orthogonal basis in the Hilbert space L2 (R, φ)
of the square integrable functions on R w.r.t. the weight function φ. The
Gram-Charlier coefficients can thus be interpreted as the Fourier coefficients
of the function
P∞ f (x)/φ(x) in the Hilbert space L2 (R, φ) with the basis {Hk }
f (x)/φ(x) = k=0 ck Hk (x).) Plugging (1.12) into (1.9) gives the formal Cornish-
Fisher expansion, which is re-grouped as motivated by the central limit theo-
rem.
14 1 Approximating Value at Risk in Conditional Gaussian Models

Assume that ∆V is already normalized (κ1 = 0, κ2 = 1) and consider the

normalized
Psum of independent random variables ∆Vi with the distribution F ,
n
Sn = √1n i=1 ∆Vi . The moment generating function of the random variable
Sn is
∞
√ 2 X
Mn (t) = M (t/ n)n = et /2 ( ck tk n−k/2 )n .
k=0

Multiplying out the last term shows that the k-th Gram-Charlier coefficient
ck (n) of Sn is a polynomial expression in n−1/2 , involving the coefficients ci up
to i = k. If the terms in the formal Cornish-Fisher expansion
∞
" ∞
!r #
r 1
X X
x=z+ (−1) D(r−1) − ck (n)Hk−1 (z) (1.13)
r=1
r!
k=1

are sorted and grouped with respect to powers of n−1/2 , the classical Cornish-
Fisher series
X∞
x=z+ n−k/2 ξk (z) (1.14)
k=1

results. (The Cornish-Fisher approximation for ∆V results from setting n = 1

in the re-grouped series (1.14).)
It is a relatively tedious process to express the adjustment terms ξk correpond-
ing to a certain power n−k/2 in the Cornish-Fisher expansion (1.14) directly
in terms of the cumulants κr , see (Hill and Davis, 1968). Lee developed a
recurrence formula for the k-th adjustment term ξk in the Cornish-Fisher ex-
pansion, which is implemented in the algorithm AS269 (Lee and Lin, 1992; Lee
and Lin, 1993). (We write the recurrence formula here, because it is incorrect
in (Lee and Lin, 1992).)
k−1
X j
ξk (H) = ak H ∗(k+1) − (ξk−j (H) − ξk−j ) ∗ (ξj − aj H ∗(j+1) ) ∗ H, (1.15)
j=1
k

κk+2
with ak = (k+2)! . ξk (H) is a formal polynomial expression in H with the usual
algebraic relations between the summation “+” and the “multiplication” “∗”.
Once ξk (H) is multiplied out in ∗-powers of H, each H ∗k is to be interpreted
as the Hermite polynomial Hk and then the whole term becomes a polynomial
in z with the “normal” multiplication “·”. ξk denotes the scalar that results
when the “normal” polynomial ξk (H) is evaluated at the fixed quantile z, while
ξk (H) denotes the expression in the (+, ∗)-algebra.
1.3 Cornish-Fisher Approximations 15

This formula is implemented by the quantlet

q = CornishFisher (z, n, cum)

Cornish-Fisher expansion for arbitrary orders for the standard
normal quantile z, order of approximation n, and the vector of
cumulants cum.

The following example prints the Cornish-Fisher approximation for increasing

orders for z=2.3 and cum=1:N:
XFGcofi.xpl

Contents of r

[1,] 2 4.2527
[2,] 3 5.3252
[3,] 4 5.0684
[4,] 5 5.2169
[5,] 6 5.1299
[6,] 7 5.1415
[7,] 8 5.255

1.3.2 Properties

The qualitative properties of the Cornish-Fisher expansion are:

+ If Fm is a sequence of distributions converging to the standard normal dis-

tribution Φ, the Edgeworth- and Cornish-Fisher approximations present
better approximations (asymptotically for m → ∞) than the normal ap-
proximation itself.
− The approximated functions F̃ and F̃ −1 ◦Φ are not necessarily monotone.
− F̃ has the “wrong tail behavior”, i.e., the Cornish-Fisher approximation
for α-quantiles becomes less and less reliable for α → 0 (or α → 1).
− The Edgeworth- and Cornish-Fisher approximations do not necessarily
improve (converge) for a fixed F and increasing order of approximation,
k.
16 1 Approximating Value at Risk in Conditional Gaussian Models

For more on the qualitative properties of the Cornish-Fisher approximation

see (Jaschke, 2001). It contains also an empirical analysis of the error of the
Cornish-Fisher approximation to the 99%-VaR in real-world examples as well
as its worst-case error on a certain class of one- and two-dimensional delta-
gamma-normal models:

+ The error for the 99%-VaR on the real-world examples - which turned
out to be remarkably close to normal - was about 10−6 σ, which is more
than sufficient. (The error was normalized with respect to the portfolio’s
standard deviation, σ.)
− The (lower bound on the) worst-case error for the one- and two-dimensional
problems was about 1.0σ, which corresponds to a relative error of up to
100%.

In summary, the Cornish-Fisher expansion can be a quick approximation with

sufficient accuracy in many practical situations, but it should not be used
unchecked because of its bad worst-case behavior.

1.4 Fourier Inversion

1.4.1 Error Types in Approximating the Quantile through

Fourier Inversion

Let
R ∞ fitxdenote a continuous, absolutely integrable function and φ(t) =
−∞
e f (x)dx its Fourier transform. Then, the inversion formula
Z ∞
1
f (x) = e−itx φ(t)dt (1.16)
2π −∞

holds.
The key to an error analysis of trapezoidal, equidistant approximations to the
integral (1.16)
∞
def ∆t
X
f˜(x, ∆t , t) = φ(t + k∆t )e−i(t+k∆t )x (1.17)
2π
k=−∞
1.4 Fourier Inversion 17

is the Poisson summation formula

∞
X 2π
f˜(x, ∆t , t) = f (x + j)e2πitj/∆t , (1.18)
j=−∞
∆ t

see (Abate and Whitt, 1992, p.22). If f (x) is approximated by f˜(x, ∆t , 0), the
residual X 2π
ea (x, ∆t , 0) = f (x + j) (1.19)
∆t
j6=0

is called the aliasing error, since different “pieces” of f are aliased into the
window (−π/∆t , π/∆t ). Another suitable choice is t = ∆t /2:
∞
X 2π
f˜(x, ∆t , ∆t /2) = f (x + j)(−1)j . (1.20)
j=−∞
∆t

If f is nonnegative, f˜(x, ∆t , 0) ≥ f (x). If f (x) is decreasing in |x| for |x| >

π/∆t , then f˜(x, ∆t , ∆t /2) ≤ f (x) holds for |x| < π/∆t . The aliasing error
can be controlled by letting ∆t tend to 0. It decreases only slowly when f has
“heavy tails”, or equivalently, when φ has non-smooth features.
It is practical to first decide on ∆t to control the aliasing error and then decide
on the cut-off in the sum (1.17):
˜ ∆t X
f˜(x, T, ∆t , t) = φ(t + k∆t )e−i(t+k∆t )x . (1.21)
2π
|t+k∆t |≤T

def ˜
Call et (x, T, ∆t , t) = f˜(x, T, ∆t , t) − f˜(x, ∆t , t) the truncation error.
For practical purposes, the truncation error et (x, T, ∆t , t) essentially depends
only on (x, T ) and the decision on how to choose T and ∆t can be decoupled.
et (x, T, ∆t , t) converges to
ZT
def1
et (x, T ) = e−itx φ(t)dt − f (x) (1.22)
2π
−T
Rπ sin(πx) def
for ∆t ↓ 0. Using 1
2π −π
e−itx dt = πx = sinc(x) and the convolution
theorem, one gets
π/∆
Z x Z ∞
1
e−itx φ(t)dt = f (y∆x ) sinc(x/∆x − y)dy, (1.23)
2π −∞
−π/∆x
18 1 Approximating Value at Risk in Conditional Gaussian Models

which provides an explicit expression for the truncation error et (x, T ) in terms
of f . It decreases only slowly with T ↑ ∞ (∆x ↓ 0) if f does not have infinitely
many derivatives, or equivalently, φ has “power tails”. The following lemma
leads to the asymptotics of the truncation error in this case.
R∞
LEMMA 1.1 If limt→∞ α(t) = 1, ν > 0, and T α(t)t−ν eit dt exists and is
finite for some T , then
Z ∞ (
−ν itx
1
T −ν+1 if x = 0
α(t)t e dt ∼ ν−1
i −ν ixT
(1.24)
T xT e if x 6= 0

for T → ∞.

PROOF:
Under the given conditions, both the left and the right hand side converge to 0,
so l’Hospital’s rule is applicable to the ratio of the left and right hand sides. 

THEOREM 1.1 If the asymptotic behavior of a Fourier transform φ of a

function f can be described as

φ(t) = w|t|−ν eib sign(t)+ix∗ t α(t) (1.25)

with limt→∞ α(t) = 1, then the truncation error (1.22)

Z ∞ 
1 −itx
et (x, T ) = − < φ(t)e dt
π T

where < denotes the real part, has the asymptotic behavior

wT −ν+1
(
π(1−ν) cos(b) if x = x∗
∼ wT −ν π
(1.26)
− π(x∗ −x)
cos(b + 2 + (x∗ − x)T ) if x 6= x∗
RT
for T → ∞ at all points x where 2π 1
−T
φ(t)e−itx converges to f (x). (If in the
first case cos(b) = 0, this shall mean that limT →∞ et (x; T )T ν−1 = 0.)
1.4 Fourier Inversion 19

PROOF:
The previous lemma is applicable for all points x where the Fourier inversion
integral converges. 

The theorem completely characterizes the truncation error for those cases,
where f has a “critical point of non-smoothness” and has a higher degree of
smoothness everywhere else. The truncation error decreases one power faster
away from the critical point than at the critical point. Its amplitude is inversely
proportional to the distance from the critical point.
Let F̃ be a (continuous) approximation to a (differentiable) cdf F with f =
F 0 > 0. Denote by  ≥ |F̃ (x) − F (x)| a known error-bound for the cdf. Any
solution q̃(x) to F̃ (q̃(x)) = F (x) may be considered an approximation to the
true F (x)-quantile x. Call eq (x) = q̃(x) − x the quantile error. Obviously, the
quantile error can be bounded by

|eq (x)| ≤ , (1.27)
inf y∈U f (y)

where U is a suitable neighborhood of x. Given a sequence of approximations

F̃ with supx |F̃ (x) − F (x)| =  → 0,

F (x) − F̃ (x)

eq (x) ∼ ( → 0) (1.28)
f (x)

holds.
FFT-based Fourier inversion yields approximations for the cdf F on equidistant
∆x -spaced grids. Depending on the smoothness of F , linear or higher-order
interpolations may be used. Any monotone interpolation of {F (x0 + ∆x j)}j
yields a quantile approximation whose interpolation error can be bounded by
∆x . This bound can be improved if an upper bound on the density f in a
suitable neighborhood of the true quantile is known.
20 1 Approximating Value at Risk in Conditional Gaussian Models

1.4.2 Tail Behavior

2 2
If λj = 0 for some j, then |φ(t)| = O(e−δj t /2 ). In the following, we assume
that |λi | > 0 for all i. The norm of φ(t) has the form
m
δ 2 t2 /2
Y  
|φ(t)| = (1 + λ2i t2 )−1/4 exp − i 2 2 , (1.29)
i=1
1 + λi t
|φ(t)| ∼ w∗ |t|−m/2 |t| → ∞ (1.30)

with
m  
def
Y 1
w∗ = |λi |−1/2 exp − (δi /λi )2 . (1.31)
i=1
2
The arg has the form
m
X 1 1 λi t
arg φ(t) = θt + arctan(λi t) − δi2 t2 , (1.32)
i=1
2 2 1 + λ2i t2
m 
δi2 t

X π
arg φ(t) ∼ θt + sign(λi t) − ) (1.33)
i=1
4 2λi

(for |t| → ∞). This motivates the following approximation for φ:

def  π
φ̃(t) = w∗ |t|−m/2 exp i m∗ sign(t) + ix∗ t (1.34)
4
with
m
def
X
m∗ = sign(λi ), (1.35)
i=1
m
def 1 X δi2
x∗ = θ − . (1.36)
2 i=1 λi
x∗ is the location and w∗ the “weight” of the singularity. The multivariate
delta-gamma-distribution is C ∞ except at x∗ , where the highest continuous
derivative of the cdf is of order [(m − 1)/2].
Note that
def
Y 1 δj2
α(t) = φ(t)/φ̃(t) = (1 − (iλj t)−1 )−1/2 exp{ 2 (1 − iλj t)−1 } (1.37)
j
2 λj

and α meets the assumptions of theorem 1.1.

1.4 Fourier Inversion 21

1.4.3 Inversion of the cdf minus the Gaussian Approximation

Assume that F is a cdf with mean µ and standard deviation σ, then

Z ∞
1 i 2 2
F (x) − Φ(x; µ, σ) = e−ixt (φ(t) − eiµt−σ t /2 ) dt (1.38)
2π −∞ t
holds, where Φ(.; µ, σ) is the normal cdf with mean µ and standard deviation
2 2
σ and eiµt−σ t /2 its characteristic function. (Integrating the inversion formula
(1.16) w.r.t. x and applying Fubini’s theorem leads to (1.38).) Applying the
Fourier inversion to F (x) − Φ(x; µ, σ) instead of F (x) solves the (numerical)
problem that ti φ(t) has a pole at 0. Alternative distributions with known
Fourier transform may be chosen if they better approximate the distribution
F under consideration.
The moments of the delta-gamma-distribution can be derived from (1.3) and
(1.5):
X 1 1
µ= (θi + λi ) = θ> 11 + tr(ΓΣ)
i
2 2
and X 1 1
σ2 = (δi2 + λ2i ) = ∆> Σ∆ + tr((ΓΣ)2 ).
i
2 2

def 2 2
Let ψ(t) = ti (φ(t)−eiµt−σ t /2 ). Since ψ(−t) = ψ(t), the truncated sum (1.21)
can for t = ∆t /2 and T = (K − 21 )∆t be written as
K−1
!
˜ ∆t X 1 −i((k+ 12 )∆t )xj
F̃ (xj ; T, ∆t , t) − Φ(xj ) = < ψ((k + )∆t )e ,
π 2
k=0

which can comfortably be computed by a FFT with modulus N ≥ K:

K−1
∆t ∆t X 1
< e−i 2 xj ψ((k + )∆t )e−ik∆t x0 e−2πikj/N ,


= (1.39)
π 2
k=0

with ∆x ∆t = 2π
N and the last N − K components of the input vector to the
FFT are padded with zeros.
The aliasing error of the approximation (1.20) applied to F − N is
X 2π 2π

ea (x, ∆t , ∆t /2) = F (x + j) − Φ(x + j) (−1)j . (1.40)
∆t ∆t
j6=0
22 1 Approximating Value at Risk in Conditional Gaussian Models

√ √
The cases (λ, δ, θ) = (± 2, 0, ∓ 2/2) are the ones with the fattest tails and
are thus candidates for the worst case for (1.40), asymptotically for ∆t → 0. In
these cases, (1.40) is eventually an alternating sequence of decreasing absolute
value and thus
r
2 − 1 √2π/∆t
F (−π/∆t ) + 1 − F (π/∆t ) ≤ e 2 (1.41)
πe
is an asymptotic bound for the aliasing error.
The truncation error (1.22) applied to F − N is
Z ∞ 
1 i 2 2
φ(t) − eiµt−σ t /2 dt .


et (x; T ) = − < (1.42)
π T t

The Gaussian part plays no role asymptotically for T → ∞ and Theorem 1.1
applies with ν = m/2 + 1.
The quantile error for a given parameter ϑ is

eϑa (q(ϑ); ∆t ) + eϑt (q(ϑ); T )

q̃(ϑ) − q(ϑ) ∼ − , (1.43)
f ϑ (q(ϑ))

asymptotically for T → ∞ and ∆t → 0. (q(ϑ) denotes the true 1%-quantile

for the triplet ϑ = (θ, ∆, Γ).) The problem is now to find the right trade-off
between “aliasing error” and “truncation error”, i.e., to choose ∆t optimally
for a given K.
Empirical
√ √observation of the one- and two-factor cases shows that (λ, δ, θ) =
(− 2, 0, 2/2) √ has√the smallest density (≈ 0.008) at the 1%-quantile. Since
(λ, δ, θ) = (− 2, 0, 2/2) is the case with the maximal “aliasing error” as well,
it is the only candidate for the worst case of the ratio of the “aliasing error”
over the density (at the 1%-quantile).
The question which ϑ is the worst case for the ratio of the “truncation error”
over the density (at the 1%-quantile)
√ is not
√ as clear-cut. Empirical observation
shows that the case (λ, δ, θ) = (− 2, 0, 2/2) is also the worst case for this
ratio over a range of parameters in one- and two-factor problems. This leads to
the following heuristic to choose ∆t for a given K (T = (K − 0.5)∆t ). Choose
∆t such as to minimize
√ √the sum of the aliasing and truncation errors for the
case (λ, δ, θ) = (− 2, 0, 2/2), as approximated by the bounds (1.41) and
w
lim sup |et (x, T )|T 3/2 = (1.44)
T →∞ π|x∗ − x|
1.4 Fourier Inversion 23

√
with w = 2−1/4 , x∗ = 2/2, and the 1%-quantile x ≈ −3.98. (Note that this
is suitable only for intermediate K, leading to accuracies of 1 to 4 digits in the
quantile. For higher K, other cases become the worst case for the ratio of the
truncation error over the density at the quantile.)
Since F − N has a kink in the case m = 1, λ 6= 0, higher-order interpolations
are futile in non-adaptive methods and ∆x = N2π ∆t is a suitable upper bound
for the interpolation error. By experimentation, N ≈ 4K suffices to keep the
interpolation error comparatively small.
K = 26 evaluations of φ (N = 28 ) suffice to ensure an accuracy of 1 digit in the
approximation of the 1%-quantile over a sample of one- and two-factor cases.
K = 29 function evaluations are needed for two digits accuracy. The XploRe
implementation of the Fourier inversion is split up as follows:

z= VaRcharfDGF2(t,par)
def 2 2
implements the function ψ(t) = ti (φ(t)−eiµt−σ t /2 ) for the com-
plex argument t and the parameter list par.
z= VaRcorrfDGF2(x,par)
implements the correction term Φ(x, µ, σ 2 ) for the argument x
and the parameter list par.
vec= gFourierInversion(N,K,dt,t0,x0,charf,par)
implements a generic Fourier inversion like in (1.39). charf is a
string naming the function to be substituted for ψ in (1.39). par
is the parameter list passed to charf.

gFourierInversion can be applied to VaRcharfDG, giving the density, or to

VaRcharfDGF2, giving the cdf minus the Gaussian approximation. The three
auxiliary functions are used by
24 1 Approximating Value at Risk in Conditional Gaussian Models

l= VaRcdfDG(par,N,K,dt)
to approximate the cumulative distribution function (cdf) of the
distribution from the class of quadratic forms of Gaussian vectors
with parameter list par. The output is a list of two vectors x and
y, containing the cdf-approximation on a grid given by x.
q= cdf2quant(a,l)
approximates the a-quantile from the list l, as returned from
VaRcdfDG.
q= VaRqDG(a,par,N,K,dt)
calls VaRcdfDG and cdf2quant to approximate an a-quantile for
the distribution of the class of quadratic forms of Gaussian vectors
that is defined by the parameter list par.

The following example plots the 1%-quantile for a one-parametric family of the
class of quadratic forms of one- and two-dimensional Gaussian vectors:
XFGqDGtest.xpl

1.5 Variance Reduction Techniques in

Monte-Carlo Simulation

1.5.1 Monte-Carlo Sampling Method

The partial Monte-Carlo method is a Monte-Carlo simulation that is performed

by generating underlying prices given the statistical model and then valuing
them using the simple delta-gamma approximation. We denote X as a vector
of risk factors, ∆V as the change in portfolio value resulting from X, L as
−∆V , α as a confidence level and l as a loss threshold.
We also let

• ∆ = first order derivative with regard to risk factors

• Γ = second order derivative with regard to risk factors

1.5 Variance Reduction Techniques in Monte-Carlo Simulation 25

• ΣX = covariance matrix of risk factors

Equation 1.1 defines the class of Delta-Gamma normal methods. The detailed
procedures to implement the partial Monte-Carlo method are as follows

1. Generate N scenarios by simulating risk factors X1 , ..., XN according to

ΣX ;
2. Revalue the portfolio and determine the loss in the portfolio values L1 , ..., LN
using the simple delta-gamma approximation;
3. Calculate the fraction of scenarios in which losses exceed l:
N
X
N −1 1(Li > l), (1.45)
i=1

where 1(Li > l) = 1 if Li > l and 0 otherwise.

The partial Monte-Carlo method is flexible and easy to implement. It provides

the accurate estimation of the VaR when the loss function is approximately
quadratic. However, one drawback is that for a large number of risk factors,
it requires a large number of replications and takes a long computational time.
According to Boyle, Broadie and √ Glasserman (1998), the convergence rate of
the Monte-Carlo estimate is 1/ N . Different variance reduction techniques
have been developed to increase the precision and speed up the process. In
the next section, we will give a brief overview of different types of variance
reduction techniques, Boyle et al. (1998).

1. Antithetic Method
We assume Wi = f (zi ), where zi ∈ Rm are independent samples from the
standard normal distribution. In our case, the function f is defined as
m
X 1
f (zi ) = I(Li > l) = I[− (δi zi + λi zi2 ) > l]. (1.46)
i=1
2

Based on N replications, an unbiased estimator of the µ = E(W ) is given

by
N N
1 X 1 X
µ̂ = Wi = f (zi ). (1.47)
N i=1 N i=1
26 1 Approximating Value at Risk in Conditional Gaussian Models

In this context, the method of antithetic variates is based on the obser-

vation that if zi has a standard normal distribution, then so does −zi .
Similarly, each
N
1 X
µ̃ = f (−zi ) (1.48)
N i=1

is also an unbiased estimator of µ. Therefore,

µ̂ + µ̃
µ̂AV = (1.49)
2

is an unbiased estimator of µ as well.

The intuition behind the antithetic method is that the random inputs
obtained from the collection of antithetic pairs (zi , −zi ) are more regularly
distributed than a collection of 2N independent samples. In particular,
the sample mean over the antithetic pairs always equals the population
mean of 0, whereas the mean over finitely many independent samples is
almost surely different from 0.
2. Control Variates
The basic idea of control variates is to replace the evaluation of an un-
known expectation with the evaluation of the difference between the un-
known quantity and another expectation whose value is known. PN The
standard Monte-Carlo estimate of µ = E[Wi ] = E[f (zi )] is N1 i=1 Wi .
Suppose we know µ̃ = E[g(zi )]. The method of control variates uses the
known error
N
1 X
W̃i − µ̃ (1.50)
N i=1
to reduce the unknown error
N
1 X
Wi − µ. (1.51)
N i=1

The controlled estimator has the form

N N
1 X 1 X
Wi − β( W̃i − µ̃). (1.52)
N i=1 N i=1

Since the term in parentheses has expectation zero, equation (1.52) pro-
vides an unbiased estimator of µ as long as β is independent. In practice,
1.5 Variance Reduction Techniques in Monte-Carlo Simulation 27

if the function g(zi ) provides a close approximation of f (zi ), we usually

set β = 1 to simplify the calculation.
3. Moment Matching Method
Let zi , i = 1, ..., n, denote an independent standard normal random vec-
tor used to drive a simulation. The sample moments will not exactly
match those of the standard normal. The idea of moment matching is to
transform the zi to match a finite number of the moments of the underly-
ing population. For example, the first and second moment of the normal
random number can be matched by defining
σz
z˜i = (zi − z̃) + µz , i = 1, .....n (1.53)
sz
where z̃ is the sample mean of the zi , σz is the population standard devi-
ation, sz is the sample standard deviation of zi , and µz is the population
mean.
The moment matching method can be extended to match covariance and
higher moments as well.
4. Stratified Sampling
Like many variance reduction techniques, stratified sampling seeks to
make the inputs to simulation more regular than the random inputs. In
stratified sampling, rather than drawing zi randomly and independent
from a given distribution, the method ensures that fixed fractions of the
samples fall within specified ranges. For example, we want to generate
N m-dimensional normal random vectors for simulation input. The em-
pirical distribution of an independent sample (z1 , . . . , zN ) will look only
roughly like the true normal density; the rare events - which are im-
portant for calculating the VaR - will inevitably be underrepresented.
Stratified sampling can be used to ensure that exactly one observation
zik lies between the (i − 1)/N and i/N quantiles (i = 1, ..., N ) of the k-th
marginal distribution for each of the m components. One way to imple-
ment that is to generate N m independent uniform random numbers uki
on [0, 1] (k = 1, . . . , m, i = 1, . . . , N ) and set

z̃ik = Φ−1 [(i + uki − 1)/N ], i = 1, ...., N (1.54)

where Φ−1 is the inverse of the standard normal cdf. (In order to achieve
satisfactory sampling results, we need a good numerical procedure to cal-
culate Φ−1 .) An alternative is to apply the stratification only to the most
28 1 Approximating Value at Risk in Conditional Gaussian Models

important components (directions), usually associated to the eigenvalues

of largest absolute value.
5. Latin Hypercube Sampling
The Latin Hypercube Sampling method was first introduced by McKay,
Beckman and Conover (1979). In the Latin Hypercube Sampling method,
the range of probable values for each component uki is divided into N seg-
ments of equal probability. Thus, the m-dimensional space, consisting of
k parameters, is partitioned into N m cells, each having equal probability.
For example, for the case of dimension m = 2 and N = 10 segments, the
parameter space is divided into 10 × 10 cells. The next step is to choose
10 cells from the 10 × 10 cells. First, the uniform random numbers are
generated to calculate the cell number. The cell number indicates the
segment number the sample belongs to, with respect to each of the pa-
rameters. For example, a cell number (1,8) indicates that the sample
lies in the segment 1 with respect to first parameter, segment 10 with
respect to second parameter. At each successive step, a random sample
is generated, and is accepted only if it does not agree with any previous
sample on any of the segment numbers.
6. Importance sampling
The technique builds on the observation that an expectation under one
probability measure can be expressed as an expectation under another
through the use of a likelihood ratio. The intuition behind the method is
to generate more samples from the region that is more important to the
practical problem at hand. In next the section, we will give a detailed
description of calculating VaR by the partial Monte-Carlo method with
importance sampling.

1.5.2 Partial Monte-Carlo with Importance Sampling

In the basic partial Monte-Carlo method, the problem of sampling changes in

market risk factors Xi is transformed into a problem of sampling the vector z of
underlying standard normal random variables. In importance sampling, we will
change the distribution of z from N(0, I) to N(µ, Σ). The key steps proposed
by Glasserman, Heidelberger and Shahabuddin (2000) are to calculate

P (L > l) = Eµ,Σ [θ(z)I(L > l)] (1.55)

Other documents randomly have
different content
 TURKOMAN MUSICIANS

The warp is merely a piece of canvas pegged out on the ground,

with the transverse threads removed. The weaver, who crouches
over her handiwork, takes a pinch of coloured wool and, with a deft
twist of her fingers, attaches it to one of the horizontal threads,
pressing it afterwards into position with a heavy wooden comb. It is
a curious fact that the intricate patterns are never committed to
paper, and have been handed down from mother to daughter from
generations unnumbered. The marriage customs of the Turkomans
are unique. Polygamy is permitted by the Mohammedan law, but
rarely can a Tekke afford the separate kibitka and establishment
which any wife is entitled to demand. Wedded life begins early—at
fourteen or fifteen for males, and in the case of girls before the age
of puberty. As married women wear no veils, a youth has little
difficulty in selecting his future bride. When a damsel has found
favour in his eyes he waits on her father and offers a given price for
her—slaves, horses, or cattle to the value of £40 to £80. This
essential once agreed upon, the father-in-law presents the young
couple with a new kibitka, āk ev, untarnished by smoke, in which the
relatives assemble. Then a mullā recites a few verses from the Koran
608
—and the wedded pair are left to themselves. Should the price
agreed on be not paid, at once the bride returns to her parents after
a brief honeymoon. In old times her absence stimulated the youthful
husband to prowess in distant raids, which afforded the only
opportunity of gaining the needful wealth.
 CHAPTER V

The Last Step in Advance

The ignominious campaign of 1861 was the last organised effort put
forward by Persia to protect her northern provinces. Secure in a
609
splendid strategic position, the Tekkes extended their devastations
610
far and wide. When, in 1871, a fearful famine more than
decimated the population of Khorāsān, bands of Tekke horsemen
took advantage of their neighbours’ weakness to sweep the entire
province with their marauding parties. It would have been an easy
task to check the aggression which depopulated the richest province
of Persia and caused incredible misery to the people. But so utterly
corrupt was the administration of the Shāh that the governing class
found its account in encouraging the perpetrators. Troops were paid
for by Government which existed only on paper, and the local
authorities shared in the Tekkes’ booty. The first effectual blow
struck at this gigantic machinery for plunder and oppression was the
direct result of the Khivan campaign of 1873. General Kauffman had
encountered some opposition from the Yomud Turkomans who
ranged the desert of Khiva, and he was not a man to tolerate half-
measures. He waged a war of extermination against this once
powerful tribe, and the ruthless cruelty that attended it struck terror
throughout the southern steppes. The Gokhlan Turkomans,
inhabiting the estuary of the Atrak and the rich valleys behind it, had
been brought to heel by an energetic governor of the Persian
611
province of Bajnard in 1869, and their piracies on the Caspian had
been put down with a strong hand by the Russian naval
 612
authorities. With the pacification of Khiva, too, came the
formation, in 1874, of a Transcaspian military district, subordinate to
613
the Caucasus, which was placed under the governorship of Major-
General Lomakin. On the north-west the Tekkes saw an iron wall
arise which checked their aggressions and was a standing menace to
their independence. Nor were the prospects in the west of their
habitat more encouraging. The Russian treaties with Khiva and
Bokhārā forbade slavery, and closed the principal markets for the
captives of their bow and spear. In 1877 the Tekkes turned to Persia,
and made her an offer of their allegiance in return for support
against the white man’s encroachments. This contingency was not to
be regarded with equanimity by the Russians, for they rightly
considered the Turkomans as within the sphere of influence of the
614
Transcaspian district. Nor were commercial considerations
wanting. Russia was by this time the virtual mistress of the
Khānates, and was directly interested in the development of their
trade; but caravans were unable to cross the Turkoman Desert while
the nomads remained untamed, and were driven to take circuitous
615
routes in order to reach the commercial centre of Orenburg. And
the authorities in St. Petersburg were still dominated by the schemes
first promulgated by Peter the Great for diverting the course of the
Oxus into the Caspian, and regarded the Turkoman Desert as a
potential breeding-ground for cattle which would supply the home
markets with hides. The Tsar Alexander II. was thus led, much
against his wish, to permit his lieutenants to adopt a forward policy
against the one obstacle to the Russification of Central Asia. In the
spring of 1877 General Lomakin received orders to occupy the Tekke
616
fortress of Kizil Arvat, 200 miles east of Krasnovodsk. He set out
on the 12th of April with 9 companies of infantry, 2 squadrons of
Cossacks, and 8 guns, and soon came to blows with the Tekkes. His
artillery and arms of precision struck terror into their hearts. They
dispersed and afterwards sent delegates from every village of the
Akkal oasis to offer submission; but Lomakin did not wait to receive
it. Seized with a sudden panic, he retreated on the 9th of June. Then
came the Russo-Turkish War, and the Tsar had more than enough to
occupy his attention nearer home. The Turkomans were left
617
unmolested for a while, but hardly had peace been restored ere
measures were concerted against the tribesmen. In April of that year
General Lazareff advanced with an expeditionary force from
Chikisliar, near the mouth of the Atrak, and on his death, which took
place at Chat, higher up that river, command was assumed by
General Lomakin. The Kopet Dāgh Mountains were crossed by the
Bendesen Pass; and on 9th September an attack was delivered on
618
the Turkomans’ entrenched camp at Dangil Teppe, which
contained 15,000 Tekke warriors, with 5000 women and children.
The kibitkas, crowded within its clay ramparts, were raked by
artillery fire, and the fugitives were driven back into this hell on
earth by Russian cavalry. On 9th September an attempt was made to
storm the stronghold, but, maddened by their losses, and inspired
by their women to resist, the Tekkes fought like demons. Lomakin
was defeated with a loss of 450 killed and wounded, and retreated
on Chikisliar with the remains of his shattered force. The news of his
reverse was carried at lightning speed through the length and
breadth of Central Asia. Turkoman bands made their appearance on
the Amū Daryā, proclaiming the victory with all the hyperbole which
is a special gift of Asiatics. They even presented the Khān of Khiva
with Russian rifles and revolvers abandoned during the abortive
siege of Dangil Teppe, alleging that the spoils of war were so
619
abundant that they had no use for them. Their raids were carried
on with greater activity than ever. At the commencement of 1880 a
horde 3000 strong swept the banks of the Amū Daryā in Bokhāran
territory and plundered some villages close to the fortress of
Charjūy. The shock to Russian prestige can be compared only to that
suffered by ourselves when the news of the Mirat rising in 1857 was
flashed by telegraph over India. Even the dauntless Skobeleff began
to despair of the destinies of his country. “If we consider our position
during the last six years,” he wrote to St. Petersburg, “we cannot
avoid regarding the abyss which opens before us with terror, for it
may well disorganise the economic and political condition of the
 620
empire. The English have succeeded in convincing Asiatics that
they have forced us to stop before Constantinople and abandon the
Balkan peninsula. Thanks to their agents’ zeal, a version of the
Treaty of Berlin, very disadvantageous to ourselves, has been spread
throughout Asia. Great God, what sacrifices of blood and honour will
this peace, so painful to Russian hearts, entail!” To this illustrious
soldier the Tsar turned in his perplexity. A better choice could not
have been made. Michael Dmitriavitch Skobeleff was, at this epoch,
621
in the prime of life, and at the zenith of his preternatural activity.
His military career had begun at the age of twenty, and, two years
later, he won his spurs during the Polish Rebellion. Between 1871–
1875 he was in the thick of Central Asian affairs, one of the leaders
against Khiva, and the conqueror of Kokand. The Russo-Turkish War
of 1877–1878 found employment for him nearer home. He
commanded the left wing at the storming of Plevna, and afterwards
took Adrianople; but experience and military genius are of small
avail without that magnetic personal attraction which is inborn only
in the greatest leaders. Skobeleff possessed this heaven-sent gift.
“He was the God of War personified,” said his trusted lieutenant,
General Kurapatkine; and his troops loved him with a passionate
ardour which no general has inspired since the days of Napoleon. A
conference took place in January 1880 between the Tsar Alexander
II. and his brilliant subject, followed by others at the Ministry of War
presided over by General Miliutine. The ways and means were fully
discussed. It became clear that the failure of 1879 was due to
defective transport. The camels on which General Lomakin relied
perished by thousands in the desert, and he found himself, at a
critical moment, without the means of continuing the siege of Geok
622
Teppe. By one of those happy inspirations which flash on the
brain of men of genius, Skobeleff was led to invoke the aid of steam.
He knew that the desert was a dead level, without rivers to bridge,
and that a scarcity of water was the only difficulty before his
engineers. Nay, his eagle eye ranged far beyond the needs of the
moment, and clearly foresaw the advantages which would flow from
623
a railway connecting the Caspian and the Amū Daryā. A special
railway battalion was formed, and materials for a portable line on
the Decauville system were brought to Uzun Ada, the base on the
Gulf of Michaelovsk. Before the close of 1880 the section between
that post and Mullā Kārī, a distance of thirteen miles, was
completed. The control of the expedition was vested in the
commander-in-chief of the Caucasus, but a free hand was practically
given to Skobeleff, who was named “Temporary Commander of
Troops operating in Transcaspia.” He obtained full powers to prepare
and execute military operations, to negotiate with the neighbouring
native states, and to organise the administration of conquered
territories. Skobeleff knew that Orientals attach an exaggerated
importance to artillery. “To conquer,” he said, “is to astonish.”
Nothing has so marked an effect in Asia as the thunder of great
guns and the havoc wrought by shell-fire. He stipulated for ten
pieces of artillery for every 10,000 of numerical strength. Lomakin’s
abortive attack on Dangil Teppe had demonstrated the power
possessed by dense masses of felt-covered kibitkas to resist artillery
fire. Skobeleff asked for and obtained a large supply of shells
charged with petroleum, which masters the least inflammable
materials. Lastly, a plentiful supply of water is essential in a tract
where the heavens are clear for many consecutive months. A
complete distillery was established at Krasnovodsk, and it supplied
no less than 750,000 gallons daily to the troops. But the personal
equation overrides the most complete material equipment. “In war,”
said Napoleon, “men are nothing; a man is everything.” The general
bethought him of one who had been the chief of his staff in the
recent struggle with Turkey, and had shown in the darkest days of
Plevna the noblest form of courage—that which stands undismayed
in the presence of disaster. This was Colonel Alexis Kurapatkine, who
is now Minister of War at St. Petersburg. He was resting at
Samarkand from the fatigues of a recent campaign in Kulja, on the
Chinese frontier, but he hastened to obey his loved master’s call.
Starting from Samarkand in November 1880, with a detachment 500
strong, he hurried through Bokhārā to Charjūy, barely three days’
ride from the Tekke lair at Merv; then, fetching a long détour by way
of Khiva to avoid the Tekke bands with which the desert swarmed,
he joined headquarters on 24th December. Well might Skobeleff say
of him, “Kurapatkine is the only man capable of performing so
dangerous a mission.” The general’s staff was strengthened by other
great authorities in Central Asian warfare—Petrusevitch, unrivalled
for his knowledge of the Turkomans; Grodekoff, and Leokovitch,
professor at the War Academy. Meantime Skobeleff had reached
Chikisliar in May, and after a general survey of the situation had
pushed forward to Bami, a Turkoman post at the entrance of the
Akkal oasis, which commands the route by way of Chikisliar and
Krasnovodsk, and is only seventy miles from the capital, Geok
Teppe. He occupied this stronghold on the 10th of June, and on the
13th of the following month advanced at the head of 1000 men to
reconnoitre the enemy’s central settlement. Arriving on the fourth
day at Egman Batir, a Tekke village six miles from Geok Teppe, he
formed an entrenched camp there and sallied forth to inspect the
Tekkes’ position. He found them crowded into three camps,
surrounded by clay ramparts. The fort at the base of the hills was
known as Yangi Kal`a; the second, or central position, Dangil Teppe,
from a mound at the north-western corner; the third was an
insignificant collection of huts, called Geok Teppe, which, by a
process akin to that which has produced the nomenclature of Arbela
and Waterloo, has given its name to the scene of the last great
battle of Central Asia. Having ascertained that the hornets’ nest
could be taken only after a regular siege, Skobeleff’s little band
returned to Bami, which had been christened Fort Samursk. He was
harassed during retirement by clouds of Turkomans, whose activity
in checking the arrival of supplies extended far into the rear of the
Russian advanced base at Kizil Arvat. The ensuing months were
occupied in active preparation for the siege. A force of 12,000 men
and 100 guns had been summoned from the Caucasus, and the
Russians were engaged in completing the railway and providing the
vast mass of stores needed for a march through 300 miles of desert.
In the beginning of December 1880 all preparations were completed,
and Skobeleff advanced in force, occupying all the Tekke settlements
in succession between Bami and Egman Batir, or Samursk. He
arrived at this point of vantage on the 16th December. A
reconnaissance made on the following day showed the majority of
the foe massed in Dangil Teppe, the central encampment, an
irregular parallelogram with an area of a square mile. It was
surrounded by a mud wall with a profile 18 feet thick, and 10 feet
high on the interior side, the exterior varying with the soil, but
averaging, perhaps, 15 feet; a ditch which could not have been more
than 4 feet deep. At the north-west corner was the mound from
which the fortress derived its name, on which was planted the only
piece of artillery possessed by the Turkomans—an antiquated
smooth-bore captured from the Persians. The 30,000 Tekkes massed
within these rude entrenchments obtained water from a stream
which flowed through the place. This the Russians intentionally
refrained from diverting, lest the quarry should desert its lair under
cover of the night. No forward movement was made for more than a
week. The interval was probably spent in forming depôts for
supplies; but it is, perhaps, more than a coincidence that the next
movement took place on the 24th December—the day of
Kurapatkine’s arrival from Samarkand. It was a reconnaissance in
force, which encountered a huge mob of Turkomans, and was hard
pressed until the arrival of reinforcements. A further delay of eight
days followed, and then, on 1st January 1881, a fierce attack was
delivered on Yangi Kal`a, the encampment at the foot of the cliffs,
by 8000 troops in three columns, with 52 pieces of cannon and 11
Hotchkiss machine guns. The southern column, commanded by
General Kurapatkine, forced the entrenchment in the rear, and
compelled the Tekkes to evacuate Yangi Kal`a under a terrific
artillery fire and join the main body at Dangil Teppe. Twice did the
garrison sally forth to their countrymen’s help, and when night fell
they made a determined attempt to recapture Yangi Kal`a, but on
each occasion they were driven back by the Russian artillery. On the
3rd January the Russians removed their camp from Samursk to that
abandoned by the foe at Yangi Kal`a, and the following day saw the
first parallel laid against Dangil Teppe, at a distance of 800 yards
south of the fortress. This movement provoked a sortie of the
garrison, who had been reinforced by 5000 warriors from Merv. They
fell with fury on the besiegers, and, seizing their rifles with one
hand, hacked them with their razor-like blades, covering the soil in
places with heads and limbs. Nothing can be conceived more terrible
than their death-struggle at close quarters, from which arose the
624
clash of steel, shrieks, oaths, and shouts of “Allah,” or “Hurrah.”

VIEW FROM THE INTERIOR OF THE FORT OF GEOK TEPPE

On the Russian left flank more than 300 dead bodies remained
as witnesses of the Tekkes’ heroic but useless courage. This
encounter cost the besiegers one of their best and most valiant
officers, Colonel Petrusevitch, to whom we are indebted for most of
our knowledge of Turkomania at the eve of its conquest. The second
parallel was laid on the 4th January, and five days later another
determined sortie was made by the beleaguered Tekkes. At dusk
they poured into the second parallel, which was held by 2600 men,
and took possession of the outworks and trenches, destroying the
artillerymen and capturing four mountain guns and three regimental
standards. But the reserves were hurried up from the camp at Yangi
Kal`a, and after a fearful struggle the trenches were reoccupied, and
all but one of the lost guns were regained. On the 10th of January
the Tekke outposts were seized after severe fighting; but at half-past
eight the besieged made a third sortie. They stormed a redoubt on
the left flank, cut to pieces the artillerymen and a company of
Transcaspian rifles who defended it, and dragged the two cannon
which it contained towards the trenches. The Russian reserves again
deprived them of the fruit of victory; for one mountain gun only,
rendered useless by the removal of the breech-piece, was carried off
625
by the Tekkes. The time chosen by the besieged for these very
effective operations was always the dark hour between sunset and
the rise of the young moon. They inspired such terror that it was
difficult to induce the young soldiers to await the Tekkes’ onslaught.
The night of the 16th January was marked by the last of these
mighty encounters, but experience had taught the Russians many a
bitter lesson, and their tactics rendered the heroic bravery of their
626
opponents useless. On the 16th the sap had been pushed within
twenty-four yards of the east side of the entrenchments. Breaching
began on the 20th; and while a heavy fire was concentrated on a
spot near the south-eastern angle, a perfect hail of petroleum shells
was thrown on the dense mass of kibitkas packed into the Tekke
enclosure. Fearful must have been the sufferings of the 7000 women
and children who had sought refuge there. Every part of the works
was searched by the fragments of shell and streams of
unextinguishable flame. The traveller who visits the scene of this
battle of the giants is filled with wonder that an undisciplined mob
should have held out for three weeks with defences so paltry. Their
stubbornness inspired respect in Skobeleff himself, who was as
ready as all really brave men are to render justice to a gallant foe. In
a proclamation addressed to his troops on the eve of the final
assault, he told them that they were face to face with a people “full
627
of courage and honour.” But the end was drawing near. Not only
was the breach reported to be practicable on the 23rd, but a mine
had been driven under the eastern face about one hundred yards
from the angle, which was charged with dynamite by a party of
volunteers after nightfall. At seven on the morning of the 24th of
January 1881 four columns formed for the assault, commanded
respectively by General Skobeleff in person, and by Colonels
Kozelkoff, Kurapatkine, and Gaidaroff. The signal was given by a vast
column of smoke attended by a dull roar which rose from the
eastern front. It proclaimed the explosion of the mine, which levelled
300 feet of the rampart, and overwhelmed several hundreds of the
defenders. Instantly the force under Gaidaroff sprang forward and
escaladed the parapet on the south-western angle. This was
intended to be a feigned attack, but it soon developed into a serious
one. Pushing northwards, Gaidaroff captured the mound which
commanded the camp, and thus convinced the defenders of the
impossibility of further resistance. In the meantime the other
columns had swarmed through the breaches caused by the mine and
the artillery fire, and climbed the parapet on the southern side
between the two. The hand-to-hand encounter was brief, for the
position was clearly untenable. O’Donovan, who watched the attack
from a spur of the Kopet Dāgh twelve miles off, saw a cloud of
horsemen issuing in disorder from the northern side, followed by a
628
confused mass of fugitives. The Russian flag waved on the mound
which gave Dangil Teppe its name. It was planted at a cost to the
629
assailants of 1200 men killed and wounded, out of a total
engaged of 8000. That undergone by the garrison will never be
accurately known. Four thousand bodies were found in the
enclosure, and Skobeleff admitted that a flying column pursued and
630
hacked the fugitives for ten miles. General Kurapatkine estimates
that the enemy lost 9000 out of a total of 30,000. He strenuously
denies the oft-repeated allegation that Tekke women and children
were intentionally slaughtered. The Russians, he states, did not
wilfully kill a single non-combatant, though, of course, many must
have perished from the hail of petroleum shells which were poured
for three weeks into the doomed enclosure. So anxious, he affirms,
were his countrymen to avoid shedding innocent blood, that on the
eve of the assault the garrison were formally summoned to send
their families to a distance. The Turkomans’ reply was characteristic:
“If you want our wives and children,” they said, “you must step over
our corpses to seize them.” Fireside theorists are apt to reprobate
the bloodshed of Geok Teppe and the slaughter of the wounded foe
at Omdurman as unworthy of civilisation. A superficial acquaintance
with the Asiatic character would convince them that an extreme
application of the Virgilian debellare superbos is the least cruel policy
which can be adopted in dealing with the forces of savagery and
fanaticism. Geok Teppe was the last stronghold of Central Asian
independence, and its capture must rank among the decisive battles
of the world. While civilisation gained by the Russian victory, it is
impossible to refuse sympathy to those who were crushed by its
giant forces. With the conquest of Turkomania a national entity
disappeared for ever which had been preserved intact during ages of
change and retained many noble qualities. The world is the poorer
by the disappearance of such types, and by the gradual reduction of
all mankind to a dead level devoid of colour and charm. The news
was received with dismay by the population of the Khānates, who
still cherished hopes of regaining independence. Geok Teppe inspired
the most bigoted of Russia’s foes with a conviction of the
hopelessness of battling against the decree of fate; and to the lesson
thus learnt is due the unbroken tranquillity which reigned for
eighteen years in Central Asia. The Shāh of Persia hailed the
extirpation of the hornets’ nest with joy. He saw his northern
provinces delivered from a terrible scourge, and peace restored to a
rich territory which the corruption and incapacity of his own
government was unable to protect. Thus he at once acceded to a
suggestion made by the Russian ambassador, M. Zinovieff, that the
left bank of the Atrak, which had been virtually annexed, should be
ceded to Persia in return for the abandonment of her rather
shadowy rights as suzerain over the Merv oasis, and for authority to
push the Transcaspian Railway through territory which was still
631
nominally subject to her sway. The absorption by Russia of the
whole area inhabited by the conquered race was but a matter of
time. The Akkal oasis was hers by right of conquest, and it remained
to add that of Merv to the long list of her conquests. The way was
paved for this measure by diplomacy, the agent being an astute
632
Mohammedan named Alikhanoff. He was a native of Dāghistan in
the Caucasus, and had won the rank of colonel by gallantry in the
field. Alikhanoff found a potent ally in the person of the once
beautiful Gul Jamāl, widow of the last great chieftain, Nūr Verdi
Khān, who enjoyed universal respect, due alike to her own force of
character and the memory of her husband’s exploits. Her persuasion
was seconded by a military demonstration which took place on
December 1883, under Colonel Masloff; and, on the 31st January
1884, 124 delegates from the various settlements of the Merv oasis,
headed by the four tribal chiefs, met at Askabad, which had been
recently created the headquarters of the Transcaspian military
district. Here they solemnly swore fidelity to the Tsar in the presence
of the governor-general, Komaroff. A recrudescence of the old
lawless spirit followed, which was prompted by an Afghan
adventurer, but it was stifled on the 3rd of March by military force.
In the following May, Prince Dondukoff-Korsakoff, governor-general
of the Caucasus, paid a formal visit to the latest and not the least
valuable trophy of Russian diplomacy, and was able to report to his
imperial master that the inhabitants of the oasis had willingly
acknowledged his sway. Soon afterwards the Sārik tribe, numbering
65,000, who inhabited the Yolatan oasis thirty-six miles south of
Merv, tendered their submission, and that of the tribes between
Giaour and Sarakhs followed.
The tract over which Russia had gained mastery was a
parallelogram lying between the Oxus and the Harī Rūd, which
washes the walls of Herāt, and in Turkomania is known as the
Tajand. The western boundary marched with that of Persia, and at
its northern extremity was defined by Old Sarakhs, a Turkoman
village perched on an elevation which commanded a once thickly
peopled country extending northwards to Merv. Old Sarakhs was
easily accessible by wheeled traffic from Puli Khatan, a village on the
left bank of the Harī Rūd, thirty-three miles from the Zū-l-Fikār Pass,
through which the Tekke hordes had often poured into Khorāsān. To
the east of this defile lay the Paropamisus range, a double spur of
the Kūh-i-Bābā Mountains, which consists of low rolling hills covered
633
with asafœtida and thistles. The northern flank of the
Paropamisus gives rise to the Murghāb, which fertilises Merv, and its
confluent the river Kushk. The country between these streams and
634
the Harī Rūd was known as the Bādghīs, and is described by
Lessar as presenting the appearance of a stormy sea suddenly
reduced to solidity. In 1884 it had been ruined by Tekke incursions.
A few thousand Jamshīdīs still clung to the rich valley of the Kushk,
where they had been planted by Nādir Shāh in the eighteenth
century as a bulwark against Turkoman aggression, and are
described as a peaceable nomad race famed for their breed of
635
horses. On the north-west of this forlorn tract stood Bālā
Murghāb, an Afghan fortress commanding the road to Maymena;
and thirty-five miles farther north the village of Panjdih towered
above an oasis with an area of 170 square miles, peopled by the
Sārik Turkomans. Afghanistan lay to the south of the debatable land.
Its natural boundary was defined by the Paropamisus, and only
eighty miles beyond them lay Herāt. This city had played a great
part in history. It was regarded as the key to Afghanistān; the only
serious obstacle to a successful invasion of India from the north-
west; and its citadel had been fortified in 1838 under the supervision
of British officers. Nor was the importance of Herāt confined to its
strategic position. It was the emporium of Central Asian trade, and
the centre of a well-watered and fertile country. Thus the value to
Russia of her latest acquisition was immense. In Merv she possessed
a region which had been once the most fertile on the world’s
surface, and needed but settled government to resume its ancient
importance. The ill-defined area which she claimed to the south of
the Merv oasis commanded the richest province of Persia and the
north of Afghanistān. It was inevitable that the news of its
impending appropriation should excite a storm of indignation in
England, where every step of the Russian advance was watched with
the keenest suspicion. An attempt to propitiate public feeling had
been made as far back as 1882, when Russia proposed a joint
commission to demarcate the northern boundary of Afghanistān, and
at that time she would doubtless have accepted a line drawn from
Khwāja Sālih on the Oxus to Sarakhs. But the Government then in
power was not inclined to raise so delicate a question, and it was not
until June 1884, when the situation had been radically modified by
the conquest of Turkomania, that the proposal found acceptance. A
joint commission was appointed in July, charged with the duty of
laying down the disputed boundary. It was headed on the British
side by General Sir Peter Lumsden, who had won distinction in India;
while General Zelenoi was directed to watch over the interests of
Russia. Sir Peter traversed Afghanistān, with the Amīr `Abd er-
Rahmān’s permission, escorted by a little army of 500 strong with
twice as many camp followers. This demonstration, for such it was,
636
excited the suspicion of Lieutenant-General Komaroff, the military
governor of Transcaspia, and General Zelenoi was directed to return
to Tiflis. In the meantime the explorations of Lessar in the valleys of
the Murghāb and Kushk had led Russia to modify her claims. It was
contended at the conference which followed that she should be
allotted an ethnological frontier, based on the submission rendered
by the Sāriks inhabiting the Panjdih oasis. The British representative,
on the other hand, declined to recognise any other boundary than
one based on natural conditions which excluded from Russian sway
all territory south of an imaginary line drawn from Old Sarakhs to
Khwāja Sālih on the Oxus. The Gordian knot was cut by the Afghans,
who, encouraged by the presence on the Murghāb of the small
British force attending Sir Peter Lumsden, moved northwards and
occupied Bālā Murghāb and the disputed oasis of Panjdih. This
aggression elicited warm protests from Russia; and, according to her
wont, she brought material force to the aid of diplomacy. General
Komaroff occupied Pul-i-Khatun, the Zū-l-Fikār Pass, and Ak Rabāt;
and, on February 1885, he took possession of Pul-i-Kishti, at the
edge of the Panjdih oasis. The alarm excited in England was intense.
Engineers were despatched to place the fortifications of Herāt in a
state of defence; arms and ammunition were poured into Afghan
arsenals, and troops were massed under General (afterwards Lord)
Roberts on the north-western boundary of India. The match was laid
to the train by Lieutenant-General Komaroff. On the 30th of March
637
1885 his little force of 1200 men all told attacked and routed an
Afghan mob 46,000 strong with six guns, which latter fell into
638
Komaroff’s hands. The discomfited Afghans at once retired to
Merūchak, at the eastern extremity of the oasis. The skirmish, for
such it was, aroused a storm in England, and war was considered
inevitable. Parliament voted unanimously a credit of £11,000,000
sterling for military preparations; while Russia called into existence a
Volunteer Fleet, with the object of preying upon our commerce.
Happily for the tranquillity of Asia, the two greatest Powers were led
to pause ere they appealed to the awful arbitration of arms. General
Lumsden and his ablest coadjutor, Captain Yates, used their
influence with the Afghans to prevent a recurrence of the untoward
accident of the 30th of May; while the tact of the latter prompted
him to open overtures which were completely successful. Diplomacy,
thus assisted, won a peaceful triumph, and a basis for the
demarcation of the frontier was agreed upon. The process was
completed at the close of 1886, and in the April of the following year
the British and Russian representatives met at St. Petersburg. The
outcome of their deliberation was, on the whole, favourable to
Russia. She obtained the right bank of the Harī Rūd as far as the Zū-
l-Fikār Pass, and the valleys of the Bādghīs south of and including
the Panjdih oasis.
The southern boundary of her Asiatic possessions has advanced
to a point within fifty-three miles of Herāt as the crow flies, and
separated by no natural obstacle of importance from that great
commercial and strategic centre. On the other hand, the Amīr of
Bokhārā surrendered to the Afghans the rich pastures on the left
bank of the Amū Daryā south of Khwāja Sālih. Russia has loyally
accepted the work performed by the Boundary Commission, and has
concentrated her energies during the eleven years which have
intervened in developing the commerce and improving the
administration of the rich possessions thus added to her empire.
 The successful issue of this enterprise led, in 1895, to the
appointment of a mixed commission to demarcate the spheres of
English and Russian influence on the Pamirs. The boundaries of the
three Asiatic empires meet in those stupendous hills, but their
difficulty of access had hitherto precluded any attempt to lay them
down authoritatively. The English representatives, under the
direction of Sir M. G. Gerard, K.C.S.I., left India on the 30th June;
and, a month later, they met their Russian colleagues on the shore
of Lake Victoria, a wild mountain tarn which gives birth to the Oxus.
No time was lost in tracing the boundary prescribed in an agreement
entered into between the two Powers. Starting from the eastern side
of the lake, it follows the crest of the Sarikol range until the Chinese
frontier is reached. “From the sixth mile,” wrote Sir T. Holdich,
K.C.I.E., the chief survey officer, “a rugged and inaccessible spur of
the Sarikol range carried the boundary into regions of perpetual ice
and snow to its junction with the main range. Here, amidst a solitary
wilderness, 20,000 feet above sea-level, absolutely inaccessible to
man, and within the ken of no living creature except the Pamir
eagles, the three great empires actually meet. No more fitting tri-
junction could possibly have been found.”
The cordiality which marked the relations between the subjects
of Queen and Tsar was even more marked than on the earlier
occasion. On their arrival at the scene of action the travel-worn
Britons were hospitably received in the Russian camp, and a feeling
of good-fellowship was then and there engendered which never
afterwards grew cold. The scanty leisure left the commissioners by
their duty of traversing ninety miles of the most difficult country in
the world was devoted to races and shooting-matches.
The Kirghiz of the Russian escort astonished our countrymen by
their prowess at ulak, a struggle on horseback for a goat, similar to
the Bokhāran game of baigha. The Cossacks, too, displayed their
wondrous equestrian skill. August 3rd, the name-day of the
Dowager-Empress of Russia, was the occasion of an outdoor service,
and the sweet plaintive melody of the anthems of the Greek Church
never sounded so impressively as it did on those remote mountain
 639
heights. Every lover of his country will re-echo the hope
expressed by the Russian commissioner at a farewell banquet given
to his colleagues on 11th September 1895, that “the agreement just
concluded would be the beginning of more cordial relations between
the two countries, and of a better understanding of their national
aims and desires.”
 CHAPTER VI

The Central Asian Railways

The conception of a railway between the Caspian and the heart of

Asia took shape, as we have seen, during the campaign of Geok
Teppe, when a little portable line between the base and a point
thirteen miles inland was of good service to the transport. The new
railway battalion redoubled its efforts after the fall of the Tekke
stronghold, and before the close of 1885 the line had been carried
as far inland as the large Turkoman village of Kizil Arvat, 135 miles
from the Caspian. A mighty impulse was given to schemes for
railway extension by the cession of the Merv oasis in 1884. The
entire area between the Caspian and the Amū Daryā was now in
Russian hands, and there were no political and few natural obstacles
to delay the construction of a railway which should connect the great
arteries of traffic. But the advisers of the Tsar were by no means
unanimous in approving of the enterprise. A strong party favoured
the canalisation of the Amū Daryā, and an attempt to divert its
stream to its ancient channel, which entered the Caspian at
Krasnovodsk. Another faction pointed to the vast results achieved in
India by the network of railways, which enables a European military
force barely 60,000 strong to dominate 250,000,000 Asiatics; and
urged the necessity of providing the means of rapid transport of
troops and material between the Caucasus and the new strategic
bases. Foremost among the latter was General Annenkoff, who
enjoyed great influence at St. Petersburg, due less to family
connections than to his experience in the construction of railway
 640
lines. His opinion was reinforced by events in the Merv oasis, for
the collision with Afghanistān in 1884 convinced the stubbornest
advocates for water-carriage that a post of vital importance could
not be held without the assistance of a railway. In April 1885 an
imperial ukase directed the construction of a line on the standard
gauge between the Caspian and the new territories, and charged its
designer with the duty of carrying it into execution and studying the
question of extensions. General Annenkoff’s first care was to devise
a system calculated to economise time and transport, and peculiarly
adapted to countries which present few obstacles to the engineer. A
temporary line was to be laid with the utmost speed, over which the
materials and labour for completing the task might be conveyed at
leisure. The accommodation of the personnel was of equal
importance. The supervising staff consisted of three engineers-in-
chief and an army of subordinates, military and civil, selected for
their exceptional ability and vigour. Under their orders were two
battalions of railway operatives on a strictly military basis. The
second of these was recruited at Moscow by the general himself;
and both corps showed a devotion to their arduous duties which it
would be difficult to parallel. The scarcity of water in the desert
precluded the possibility of forming camps at intervals or working in
sections. By a brilliant intuition Annenkoff conceived the idea of a
camp on wheels, which would move onwards as the work
progressed, and be furnished with provisions and material by
construction trains. It contained everything needful for comfort and
efficiency. There were carriages for the office staff; dormitories and
restaurants in two-storeyed cars, a telegraph carriage, and a saloon
for the director, resembling the cabin on a man-of-war in the
compactness and modest luxury of its fittings. Each vehicle
communicated with the others by means of covered passages; and
due attention was paid to ventilation and warming. Work began on
641
the 30th of June 1885. The rails were spiked down to the sleepers
without the aid of chairs, and the rolling camp moved forwards at a
speed which was ultimately four miles a day. When Kizil Arvat had
thus been reached the soil ahead was levelled by 22,000 Tekke
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