What is Value at Risk (VaR)?
Value at Risk definition: an estimate of how much a set of investments or a single company might lose under normal market conditions over a given period (usually a day). It is used by investment managers and regulators to estimate what sort of funds would be required to cover possible losses. It is a critical measure of financial risk.
Where have you heard about Value at Risk?
If you’ve ever read a risk assessment of a portfolio of investments, you may have come across the term Value at Risk.
What you need to know about Value at Risk...
Investment and commercial banks use the Value at Risk calculation to estimate the potential losses of their investment portfolios. But given the dynamics of modern investment markets, the VaR calculation dates very quickly and becomes progressively less useful the longer the time period to which it is applied.
Understanding Value at Risk (VaR)
Value at Risk modeling calculates the potential for loss in the entity being assessed - whether this be a stock or other holding - and the probability of the occurrence of the defined loss. One way of measuring VaR is done so by assessing the amount of potential loss and the probability of the loss occurrence in a given timeframe.
For example, a financial firm may determine an asset has a 5% one-month VaR of 3%, representing a 5% chance of the asset declining in value by 3% during the one-month time frame. Converting the 5% chance of occurrence to a daily ratio puts the odds of a 3% loss at one day per month.
Additionally, VaR calculations are of little use in working out potential losses arising from so-called "black swan" events, extreme and unpredictable happenings. During the 2008 financial crisis, for example, VaR assessments were criticised for severely underestimating the risk of toxic mortgage products to banks, but the credit crunch was just such a black swan event.
Using a firm-wide VaR assessment allows for the determination of the cumulative risks from aggregated positions held by all the different trading desks and departments within the entity. Using the data provided by VaR modeling, financial institutions determine whether they have sufficient capital reserves in place to cover losses as well as determining whether higher-than-acceptable risks require them to reduce concentrated holdings.
Problems with VaR calculations
There is no standard method for selecting the data used to determine asset, portfolio, or firm-wide risk. For instance, statistics can be pulled arbitrarily from periods with low volatility and this would understate the potential for risk event occurrence as well as the magnitude of the risk in such an instance.
As well as this the assessment of potential loss represents the lowest amount of risk in a range of outcomes. For instance, a VaR figure of 95% with 20% asset risk represents an expectation of losing at least 20% one in every 20 days on average. But in this calculation, a loss of 50% still satisfies the assessment.