VaR

Value at Risk

VaR is a probabilistic method for measuring the potential loss in portfolio over a given time period and for a given distribution of historic returns.

VaR is a dollar or percentage loss in asset value that will be equaled or exceeded only percent of the time. In other words, there is an percent probability that the loss in asset value will be greater than or equal to VaR measure.

VaR has risen above the risk measure as dominating method of quantifying since 1990s. There are two reasons primarily that accounts to increase in the appeal of VaR a) Economic and Regulatory Frameworks b) Computational Appeal

Mathematical Presentation
Suppose we are considering an asset whose loss value is L, the time period at which it is considered is , the CDF of loss is F(x) and upper tail probability is p. p=Pr[L>VaR]=1- F(VaR)

Factors
The Probability: p Time Horizon: CDF: F(x) The market to market value of the position.

Properties
Monotonicity: If L1 L2, then R (L1) R(L2) Sub Additivity: R(L1+L2)R(L1)+R(L2) Positive Homogenity: R(hL)=hR(L) Translation Invariance: R(L+a)=R(L)+a

 ADVANTAGES OF VaR 1) It gives comparable and consistent measure of risk. 2) It takes accounts of correlations among assets.

VaR Measurement
Non Probabilistic Framework Let Vo be the initial value of a portfolio. The Expected Return on the portfolio is E(R) while the worst case return (extreme value) is WR. Then VaR= Vo [E(R)-WR)] Similarly absloute value of VaR=- Vo (WR)

VaR Measurement
Parametric Approach This approach is only applied with the assumption that returns are normally distributed with mean and standard deviation and z as a confidence interval. VaR through this approach is equals to VaR(T;)=-(z+)NV Where NV is the net value And T is the holding period

BACKTESTING The process in which we compare actual profits and losses to those modeled. This process identifies strengths and weakness of any model.