Value At Risk What this Means

Deb Bandyopadhyay
Sep 5, 2021
4 min read

Researched and Written by Deb Bandyopadhyay (@debadipb)

Profit & Solutions Publication

LonelyStar Consultancy Research

The most popular and traditional measure of risk is volatility. The main problem with volatility, however, is that it does not care about the direction of an investment's movement: stock can be volatile because it suddenly jumps higher. Of course, investors aren't distressed by gains. For investors, the risk is about the odds of losing money, and VAR is based on that common-sense fact. By assuming investors care about the odds of a really big loss, VAR answers the question, "What is my worst-case scenario?" or "How much could I lose in a really bad month?" Now let's get specific. A VAR statistic has three components: a time period, a confidence level and a loss amount (or loss percentage). Keep these three parts in mind as we give some examples of variations of the question that VAR answers: What is the most I can—with a 95% or 99% level of confidence—expect to lose in dollars over the next month? What is the maximum percentage I can—with 95% or 99% confidence—expect to lose over the next year? You can see how the "VAR question" has three elements: a relatively high level of confidence (typically either 95% or 99%), a time period (a day, a month or a year) and an estimate of investment loss (expressed either in dollar or percentage terms). Methods of Calculating VAR Institutional investors use VAR to evaluate portfolio risk, but in this introduction, we will use it to evaluate the risk of a single index that trades like a stock: the Nasdaq 100 Index, which is traded through the Invesco QQQ Trust. The QQQ is a very popular index of the largest non-financial stocks that trade on the Nasdaq exchange.

Value at Risk (VaR) is a financial metric that estimates the risk of an investment. More specifically, VaR is a statistical technique used to measure the amount of potential loss that could happen in an investment portfolio over a specified period of time. Value at Risk gives the probability of losing more than a given amount in a given portfolio.

Advantages of Value at Risk (VaR)

1. Easy to understand

Value at Risk is a single number that indicates the extent of risk in a given portfolio. Value at Risk is measured in either price units or as a percentage. This makes the interpretation and understanding of VaR relatively simple.

2. Applicability

Value at Risk is applicable to all types of assets – bonds, shares, derivatives, currencies, etc. Thus, VaR can be easily used by different banks and financial institutions to assess the profitability and risk of different investments, and allocate risk based on VaR.

3. Universal

The Value at Risk figure is widely used, so it is an accepted standard in buying, selling, or recommending assets.

Limitations of Value at Risk

1. Large portfolios

Calculation of Value at Risk for a portfolio not only requires one to calculate the risk and return of each asset but also the correlations between them. Thus, the greater the number or diversity of assets in a portfolio, the more difficult it is to calculate VaR.

2. Difference in methods

Different approaches to calculating VaR can lead to different results for the same portfolio.

3. Assumptions

Calculation of VaR requires one to make some assumptions and use them as inputs. If the assumptions are not valid, then neither is the VaR figure.

Key Elements of Value at Risk

Specified amount of loss in value or percentage
Time period over which the risk is assessed
Confidence interval

Example VaR Assessment Question

If we have a 95% confidence interval, what is the maximum loss that can occur from this investment over a period of one month?

Methods Used for Calculating VaR

1. Historical Method

The historical method is the simplest method for calculating Value at Risk. Market data for the last 250 days is taken to calculate the percentage change for each risk factor on each day. Each percentage change is then calculated with current market values to present 250 scenarios for future value.

For each of the scenarios, the portfolio is valued using full, non-linear pricing models. The third worst day selected is assumed to be 99% VaR.

Where:

vi is the number of variables on day i
m is the number of days from which historical data is taken

2. Parametric Method

The parametric method is also known as the variance-covariance method. It assumes a normal distribution in returns. Two factors are to be estimated – an expected return and a standard deviation.

The parametric method is best suited to risk measurement problems where the distributions are known and reliably estimated. The method is unreliable when the sample size is very small.

Let loss be ‘l’ for a portfolio ‘p’ with ‘n’ number of instruments.

For More:

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Disclaimer: This is for purely education and knowledge purpose, you can do your own research and please don't take any decision based on this information shared

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