What is Value at Risk?
What is the extent of potential financial loss within their instituition. Portfolio at a specific time interval for an asset class at a particular confidence interval. Quantifiable measure of the market risk.
Key Elements of VaR:
1. Time Period - Duration over which the risk assessment is made 2. Confidence Interval - Probability measure that indicates the certainty level with which the results can be true. Common Cl are 99% and 95%. T
Combine time period and confidence interval → Complete reporting of Value at Risk
How to calculate VaR?
1. Variance Covariance method 2. Historical Method 3. Monte Carlo Simulation Method
Why Var? 1. Risk Management - VaR provides a quantifiable measure of market risk (Potential loss) 2. Regulatory Compliances - helps in stability of the financial institution to make sure it is not overly exposed to risks → ensure enough capital reserve to cover the potential losses. 3. Portfolio Optimization-portfolio managers use Var to assess the risk associated with their portfolio and helps them to make informed decision about the asset allocation, by understanding the risk managers can optimize their portfolio by minimizing risk (variance) and maximising return 4. Performance Benchmarking - Benchmark the performance by comparing the level of risk against the level of returns
In which asset classes VaR can be used? - Equities, Derivatives, Foreign Exchanges, Fixed Incomes, and Commodities
Disadvantages: 1. Different models, different results - hard to take a decision to consider which among them 2. Model Risk Assumptions - There are cases when the assumptions does not hold and ends up creating a huge impact. Var relies heavily on Model Assumptions 3. Tail Risk - Could not account for the magnitude of the losses beyond threshold