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Value at Risk - Var: Dr. Tushar Panigrahi

Value at Risk (VaR) is a statistical technique used to measure potential portfolio losses over a specified time period at a given confidence level. It provides the maximum dollar amount expected to be lost with a certain probability. Key elements include the amount of loss, time period, and confidence interval. Financial institutions use VaR to measure firm-wide risk exposure and determine if sufficient capital reserves are in place. There are different techniques for calculating VaR such as variance-covariance, historical, and Monte Carlo methods. However, VaR has limitations as it does not indicate losses beyond the confidence level and results can vary between calculation methods.

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80 views6 pages

Value at Risk - Var: Dr. Tushar Panigrahi

Value at Risk (VaR) is a statistical technique used to measure potential portfolio losses over a specified time period at a given confidence level. It provides the maximum dollar amount expected to be lost with a certain probability. Key elements include the amount of loss, time period, and confidence interval. Financial institutions use VaR to measure firm-wide risk exposure and determine if sufficient capital reserves are in place. There are different techniques for calculating VaR such as variance-covariance, historical, and Monte Carlo methods. However, VaR has limitations as it does not indicate losses beyond the confidence level and results can vary between calculation methods.

Uploaded by

Akash Mithaulia
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Value At Risk - VaR

Dr. Tushar Panigrahi


What is Value at Risk (VAR)?
• Value at Risk (VAR) is a measurement technique that estimates the
risk of an investment. In other words, VAR is a statistical technique
that measures the amount of potential loss that could happen in
a portfolio of investment over a period of time.
• Value at Risk gives the probability of losing more than a given amount
on a given portfolio over a period of time.
• It is defined as the maximum dollar amount expected to be lost over a
given time horizon, at a pre-defined confidence level. For example, if
the 95% one-month VAR is $1 million, there is 95% confidence that
over the next month the portfolio will not lose more than $1 million.
Key Elements of Value at Risk
• Specified amount of loss in value or percentage
• Time period over which the risk is assessed
• Confidence interval
Applications of VaR
• Risk managers use VaR to measure and control the level of risk exposure.
• One can apply VaR calculations to specific positions or whole portfolios, or
to measure firm-wide risk exposure.
• Investment banks commonly apply VaR modelling to firm-wide risk due to
the potential for independent trading desks to expose the firm to highly
correlated assets unintentionally.
• Using a firm-wide VaR assessment allows for the determination of the
cumulative risks from aggregated positions held by different trading desks
and departments within the institution.
• Using the data provided by VaR modelling, financial institutions can
determine whether they have sufficient capital reserves in place to cover
losses or whether higher-than-acceptable risks require then to
reduce concentrated holdings.
different techniques of VaR calculation
• Under the parametric method, also known as variance-covariance
method, VAR is calculated as a function of mean and variance of the returns
series, assuming normal distribution.
• With the historical method, VAR is determined by taking the returns
belonging to the lowest quintile of the series (identified by the confidence
level) and observing the highest of those returns.
• The Monte Carlo method simulates large numbers of scenarios for the
portfolio and determines VAR by observing the distribution of the resulting
paths.
Drawbacks of VaR
• Firstly, while quantifying the potential loss within that level, it gives no indication of
the size of the loss associated with the tail of the probability distribution out of
the confidence level.
• Secondly, it is not additive, so VAR figures of components of a portfolio do not add
to the VAR of the overall portfolio, because this measure does not take correlations
into account and a simple addition could lead to double counting. Lastly, different
calculation methods give different results.
• Calculation of Value at Risk for a portfolio not only requires one to calculate the risk
and return of the asset but also the correlations between them. Thus, the greater
the number or diversity of assets in a portfolio, calculating VAR will be difficult.
• The different approaches in calculating VAR can lead to different results with the
same portfolio.
• Calculation of VAR requires one to make assumptions as inputs. If assumptions are
not good or are wrong, the VAR figure will also be wrong.

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