Value at risk
- Value at risk or VaR is a probability-based measure of the loss potential of a company, a fund, a portfolio, a transaction, or a strategy
- Value at risk defines three components: confidence level, time period and a loss percentage or amount
- Variance Covariance is the most common method of calculating Value at Risk
What is Value at Risk?
Value at risk or VaR is a probability-based measure of the loss potential of a company, a fund, a portfolio, a transaction, or a strategy. It is usually expressed either as a percentage or in units of currency.
Any position that exposes one to loss is a candidate for VaR measurement. VaR is most widely used to measure the loss from market risk.
Example of Value at Risk
VaR can be read as the minimum loss which is expected at a given probability for a given time period.
A company with a VaR of Rs 20 lakh at 5 percent probability in a given year will mean that there is a 5 percent probability that the company will lose a minimum of Rs 20 lakh in that year.
Methods of calculating Value at Risk?
There are three methods to calculate Value at Risk which are:
1. Historical Method
The Historical Method is the simplest method among the three to calculate Value at Risk. Historical market data is used to measure the percentage change of each risk factor for each day and then is applied to current market prices which generates a hypothetical data set. This method is based on the assumption that history would repeat itself.
2. Parametric method
The most common way of calculating VaR is the parametric method, also known as variance covariance method. This method assumes that the return of the portfolio is normally distributed and can be completely described by expected return and standard deviations.
3. Monte Carlo Method:
In this method, value at risk is measured by creating a number of different scenarios for the future using a nonlinear pricing model. This method is suited when a large variety of risk measurement problems is present.
Why is Value at Risk important?
Investors often look at risk profiles before making an investment decision. A most common parameter used to quantify risk is volatility. But volatility has one major disadvantage that it is indifferent to the direction of the fluctuations. A stock which is jumping higher can be volatile too. But of course, investors are not afraid of gains. Investors view risk as the probability of losing money and that is why Value at Risk (VaR) proves to be a better alternative.
As mentioned earlier, the value at risk question has three components: confidence level, time period and a loss percentage or amount. An example of such a VaR question is ‘What is the maximum amount in dollars I can expect to lose over the next month with 95% probability?’. As it is quite evident that value at risk is not vague and is focussed upon risk of losing money with certain probability in a particular time period.
Though usually considered as a good option to calculate risk, it is believed that it incentives investors towards ‘excessive but remote risk’.