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II. 1. A. Introduction to VaR
LO 7.1: Discuss reasons for the widespread adoption of VaR as a measure of risk.LO 7.2: Define value at risk and calculate VaR for a single asset on both a dollar and percentagebasis.LO 7.3: Convert a daily VaR measure into a weekly, monthly, or annual VaR measure.LO 7.4: Discuss assumptions underlying VaR calculations.LO 7.5: Explain why it is best to use continuously compounded rates of return when calculating VaR.LO 7.6: Calculate portfolio VaR and describe the primary factors that affect portfolio risk.
Background on value at risk (VaR)
Why it Became Popular
LO 7.1 Discuss reasons for the widespread adoption of VAR as a measure of risk
The capital asset pricing model (CAPM) is popular but controversial. CAPM divides (decomposes)risk into systemic (market) risk and residual (company-specific) risk. CAPM quantifies risk as
is controversial.Reasons for popular adoption of VAR include:The traditional approach has been the capital asset pricing model (CAPM), wherebeta is the risk metric. However, beta has a
to actual returns.Further, as a one-factor model, CAPM is viewed as too simplistic by many practitioners
JP Morgan created an “open architecture metric” (i.e., not proprietary) called
RiskMetricsBank for International Settlements (BIS) in 1998 started to allow banks to useinternal models such as VaR in order to calculate their capital requirements
JP Morgan later said about the introduction of RiskMetrics in 1994, “we took thebold step of revealing the internal risk management methodology…and a free dataset…At the time, there was little standardization in the marketplace”.
What is VAR?
LO 7.2 Define value at risk (VaR)
VaR answers a risk measurement
question (not a risk management question): “how much can welose in a given time frame, with a specified confidence level?”