Incremental VaR

If VaR gives us an indication of portfolio risks, IVaR gives us an indication of how those risks
change when we change the portfolio itself. In practice, we are often concerned with how
the portfolio risk changes when we take on a new position, in which case the IVaR is the
change in portfolio VaR associated with adding the new position to our portfolio.
Methods of Estimating IVaR
1. Brute Force: The Before and After Approach
We start with our existing portfolio p, and then input market data to obtain our portfolio
VaR, VaR(p). We then consider the candidate trade, a, construct the hypothetical new
portfolio that we would have if we went ahead with the trade, and do the same for that
portfolio. This gives us the new portfolio VaR, VaR(p+a), say. The IVaR associated with
trade/position a, IVaR(p+a), is then estimated as the difference between the two:
( ) ()
Drawback: Re-evaluating the whole portfolio VaR can be a time consuming process.
2. Estimating IVaR using Marginal VaRs
Another approach is that we estimate IVaR using a Taylor series approximation based on
marginal VaRs ( or mathematical derivatives of portfolio VaR). Again suppose we have a
portfolio p and wish to estimate the IVAR associated with adding a position a to our existing
portfolio. We begin by mapping p and a to set of n instruments. The portfolio p then has a
vector of (mapped) position sizes in these instruments of [w
1
, w
2
, . ,w
n
] (so w
1
is the
mapped position in instrument 1, etc.) and the new portfolio has a corresponding position-
size vector [w
1
+ w
1
, .. , w
n
+ w
n
]. If a is small relative to p, we can approximate the
VaR of our new portfolio (i.e. VaR(p + a)) by taking a first-order Taylor series approximation
around VaR(p), i.e.:
( ) ()

The IVaR associated with position a, IVaR(a) is then:
()

Draw