Price Risk

In derivatives, the composition of the

replicating portfolios can vary considerably
over time and maintaining these portfolios
can involve extensive and costly trading.
Even if such trading costs introduce a
degree of imprecision into derivative pricing
models, virtually all derivatives can be valued
using arbitrage models.

The standard use of derivatives is in managing
price risks through hedging.
Firms with a core business exposure to
underlying factors such as commodity prices,
exchange or interest rates, can reduce their
net exposures to these factors by assuming
offsetting exposures through derivatives.

Value at risk (VAR)
VAR is widely used risk measure of the risk of
loss on a specific portfolio of financial assets.
For a given portfolio, probability and time
horizon, VAR is defined as a threshold value
such that the probability that mark-to-market
loss on the portfolio over the given time
horizon exceeds this value.
For example, if a portfolio of stock has a one
day 95% VAR of 1 million, there is a probability
that the portfolio will fall in value by more
than 1 million over a one day period,
assuming markets are normal.