Value-at-risk is a statistical measure of the riskiness of financial entities or portfolios of assets.
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.
VAR can be calculated using different techniques. 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.
Despite being widely used, VAR suffers from a number of drawbacks. 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.
Expected shortfall, an alternative risk measure, aims at mitigating some of VAR’s flaws.
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FAQs
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.
What is the value at risk variance? ›
Value-at-risk (VaR) is a statistical method for judging the potential losses an asset, portfolio, or firm could incur over some period of time. The parametric approach to VaR uses mean-variance analysis to predict future outcomes based on past experience.
What does a 5% value at risk VaR of $1 million mean? ›
For instance, let's say an investor holds a portfolio worth $1 million in a stock that has a VAR of 5%. This means there is a 95% probability that the portfolio will not lose more than 5% of its value over a specified period.
What is VaR in simple terms? ›
Value at risk (VaR) is a statistic that quantifies the extent of possible financial losses within a firm, portfolio, or position over a specific time frame.
What is VaR and how is it calculated? ›
Value at Risk (VaR) is a statistic that is used in risk management to predict the greatest possible losses over a specific time frame. VAR is determined by three variables: period, confidence level, and the size of the possible loss.
What is my VaR value? ›
Value at Risk (VaR) is a financial metric that estimates the risk of an investment. More specifically, VaR is a statistical technique used to measure the amount of potential loss that could happen in an investment portfolio over a specified period of time.
What is an example of value at risk? ›
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.
How do you calculate variance risk? ›
How to calculate variance step-by-step
- Identify the asset's returns in a specified period. ...
- Calculate the mean of the return figures. ...
- Calculate the difference between each return figure and the average. ...
- Square these percentage differences for each year and add them together.
Risk is the combination of the probability of an event and its consequence. In general, this can be explained as: Risk = Likelihood × Impact. In particular, IT risk is the business risk associated with the use, ownership, operation, involvement, influence and adoption of IT within an enterprise.
What does 5% VaR mean? ›
The VaR calculates the potential loss of an investment with a given time frame and confidence level. For example, if a security has a 5% Daily VaR (All) of 4%: There is 95% confidence that the security will not have a larger loss than 4% in one day.
From standard normal tables, we know that the 95% one-tailed VAR corresponds to 1.645 times the standard deviation; the 99% VAR corresponds to 2.326 times sigma; and so on.
What is the VaR limit for risk? ›
Value-at-risk (VaR) is the risk measure that estimates the maximum potential loss of risk exposure given confidence level and time period. For example, a one-day 99% value-at-risk of $10 million means that 99% of the time the potential loss over a one-day period is expected to be less than or equal to $10 million.
How do you define VaR? ›
When you declare a variable with var , it is hoisted and initialized in the memory as undefined before the code execution. So, you can access the variable before declaring it, but it returns undefined . This is sometimes called Declaration hoisting.
What are the two meanings of VaR? ›
Meaning of VAR in English
abbreviation for Video Assistant Referee: an official who helps the main referee (= the person in charge of a sports game) to make decisions during a game using film recorded at the game: The VAR can ensure that no clearly wrong penalty decisions are made.
What is the formula for finding the VaR? ›
Since the definition of the log return r is the effective daily returns with continuous compounding, we use r to calculate the VaR. That is VaR= Value of amount financial position * VaR (of log return).
How is value of risk calculated? ›
The answer to, 'What is a risk value? ' is simply an estimate of the cost of risk. It's calculated by multiplying the probability of a risk occurring by the financial impact of that risk.
What is the formula for expected value of risk? ›
Expected value is calculated by multiplying each possible outcome by its probability of occurrence and then summing the results.
How do you calculate 95% VaR? ›
According to the assumption, for 95% confidence level, VaR is calculated as a mean -1.65 * standard deviation. Also, as per the assumption, for 99% confidence level, VaR is calculated as mean -2.33* standard deviation.
