Value at Risk

Question 1

What is value at risk?

Answer 1

Measure of the potential loss in a portfolio over a given time horizon within a given confidence interval assuming normal markets and no trading.

Question 2

What question does VaR answer?

Answer 2

How much could we lose in the next day (week, month or year)?W

Question 3

What does it mean when VaR is given at a 95% confidence interval?

Answer 3

95% of the time, the loss will be less than the VaR value.

Question 4

How can VaR be calculated?

Answer 4

1. Assume return values follow a probability distribution (variance or co-variance method)
2. Simulate potential return values and loss value (Monte Carlo Simulation).
3. Use historic daily returns over a define look back horizon (historical method).

Question 5

What are the disadvantages of using VaR?

Answer 5

1. Estimation error - Models have in built assumptions.
2. VaR does not indicate severity of loss
3. Does not describe the worst case scenario (Black Swan).