A quick guide to value at risk, (VAR

)

This is a simple explanation of VAR. It explains what it is, how it can be used and
some of the strengths and weaknesses it has.
What are the advantages?
VAR has several advantages, they are:
Market Risk
Traders buy and sell financial products. As a result they often have • VAR is just one number and in that sense becomes a lot
positions or exposures. These exposures can arise because they are easier to understand and monitor.
speculating or they have taken the other side of a client trade.
Whatever the reason as prices move the market value of these • VAR provides you with a statistical measure of the
positions will change. probability of loss. Risk measures like duration and basis
point value, (DV01), do not provide a statistical measure
This means that movements in foreign exchange rates, interest of the likelihood of loss. They just give you an absolute
rates, credit spreads and commodity prices lead to profits and risk figure rather than a probability of such a loss arising.
losses. This is called market risk. One of the most popular methods Therefore VAR is an improvement on these techniques.
of measuring market risk is value at risk, (VAR). It has been used
by banks for over a decade. • VAR can be calculated for all types of assets. This means
you can calculate VAR for interest rate risk, foreign
What does it show? exchange risk, credit risk and commodity price risk.
Some firms add these individual VARs together to arrive
VAR tells you how much money you can lose over a given time
at an overall VAR. You cannot do this with other risk
period and for a given level of confidence from the positions you
measures.
hold. But it is not a guaranteed maximum loss figure. Your
positions could lose you a lot more than VAR indicates.
What are the disadvantages?
Sometimes markets move by huge amounts in very short space of There are some weaknesses you should know about, they are:
time. As a consequence your dealing positions can give you losses
much greater than the VAR you have calculated. • VAR is not a maximum loss figure. From time-to-time
you may find that the actual amount of money lost
It is this point that senior managers should be aware of. VAR is not exceeds the VAR.
a guaranteed maximum loss figure. Giving your dealers a VAR limit
will not mean they cannot lose more. • If you experience a loss greater than your VAR there is
no guarantee that you will not experience another loss
What affects VAR? that exceeds your VAR the following day as well.

Four main factors influence your VAR number, they are:
• Many IT systems find the calculation of VAR challenging.
Sometimes banks rely on spreadsheets to do this.
1. Exposure: In general the larger the position you have the
Calculation errors and stale data can lead to inaccurate
greater the risk. Therefore large positions create greater
VAR reports.
VAR.
• Inaccuracy and doubts in the validity of VAR can also lead
2. Time: The longer you intend to hold the position the
to it being used as a “soft limit”. The breaking of a risk
greater the VAR. As you may expect 10 day VAR is
limit based on VAR is then treated with less seriousness
greater than 1 day VAR. (But not by a factor of 10, only
than would otherwise have been the case.
the square root of 10).
• Banks using VAR for the first time may be tempted to set
3. Confidence: If you want a VAR that is very unlikely to be
a VAR limit much higher than the risk they have. The
exceeded you will need to apply more stringent
limit is so far from being breached that no one pays
parameters. All things remaining constant this will
attention to VAR as a risk measure.
increase your VAR and make it less likely to be exceeded.
• VAR does not deal with option positions very well. It also
4. Volatility: If you deal in risky things that have a history of
does not measure operational risks. This means that you
going up and down in price, or if market conditions alter
can have losses that arise from poor controls and fraud.
to make your positions move up and down in price your
VAR will tend to increase.
Is there anything we can do to improve the
It is important to put any VAR number you see into context. This situation?
means that if you are provided with a VAR number you should also Yes. Many firms do not solely rely on VAR to manage market risk.
know: They use a variety of measures that may include traditional
techniques like basis point value and stress testing. Stress testing
1. What is the probability that it will be exceeded? shows what can happen when extreme market moves arise. It
2. What is the holding period? focuses attention to what can happen when markets move
abnormally. You can see what a bad day could really cost you. By
Without this information you will be unaware of the parameters using several measures banks are looking for consistency in the
that have been used in the calculation of the VAR that you are reporting of risk. It is like having a second, third and fourth check
working with. on VAR.

www.barbicanconsulting.co.uk
Financial Markets Training

www.5%. say one with a daily volatility of considered to be less risky than undiversified portfolios. this is the VAR**.barbicanconsulting. In real life the “tail” under the In general regulators are supportive of firms using VAR. (1 SD). In determining the time horizon you may wish diversification effect.8% certain that in normal market 00 44 (0)20 79209128 conditions your loss on holding this asset for one day will not exceed 1. interest rate trader and credit trader all lose money together. This is important. It means in theory that adding trades or products can lead to changes in the VAR that are not as great as you may anticipate.5%= 99. The volatility of your profit and loss should be decrease even when you positions remain unchanged. and the third credit. have agreed with the regulator the use of VAR in order to calculate market risk and therefore the amount of regulatory capital required ***As a rule of thumb.000 position. VAR and diversification In financial markets diversified asset portfolios are generally If you pick a more risky security. SD). ($150.000 for a $10. lognormal distribution the probability of a loss exceeding the VAR is greater than would be indicated. to support it. It is a measure of the historic or implied price what can happen in normal market conditions. It just depends on how conservative you want The undiversified VAR figure tells you what might happen on a bad your risk measure to be. VAR increases with the square root of time. Therefore if you expect 4. ----------------------------------------------------------------------------- Diversified VAR takes into account the portfolio effect. Using statistics.1%. But they are perceived market risk.co. What confidence interval and holding period should be used? That When risk managers calculate VAR they can take into account this is entirely up to you. *** day. that the price tomorrow will not fall below 100%- 0. another interest rates $300. (3 SD). A standard statistical text book will explain standard deviation. Barbican Consulting Limited chance that the price tomorrow will not fall below 100%-1. Put simply the more an asset goes up VAR & regulators and down in price the more volatile it is and the greater the Regulators will not tell you how to calculate your VAR.5% daily If you agree to use VAR then the VAR model needs to be an volatility the 10 day VAR will be 3. This is when your foreign exchange trader. a 97.co. fluctuation of dealing positions and requires observing and collecting daily asset prices. High price volatility equals high risk. banks use between 5 and 10 days with a 2 or 3 standard deviation confidence interval. (2 SD). (A theory that is anecdotally supported by some *VAR uses standard deviation. When one trader has a bad day another one This also means that if volatility changes your VAR can increase or will have a good day. there is an 84. chance that the price tomorrow William Webster will not fall below 100%-1%= 99. They can provide you with both undiversified to consider how long it could take to liquidate positions.000 on a $10m position. three traders one trading foreign exchange. Undiversified VAR is a summation of the individual product VARs. this is sometimes referred to by managers who use VAR). chance. Finally a few numbers By way of illustration the following provides a simplified VAR calculation. If you have 1% your one day VAR for a 99.5%*. Many firms distribution curve is fatter than expected. on most days you should get some diversification benefits. Many and diversified value at risk.8% confidence interval for a 10 day holding period for the asset with a 0.16 (square root 10) x 1.8%.8% confidence interval is 3%.50%. traders as volatility. It would indicate that your VAR model is inaccurate and your regulator may decide to increase the amount of regulatory capital you are holding. it can also be calculated using spreadsheet add- Many banks therefore use the diversified VAR as an indication of in functions. Increased volatility increases VAR. question how appropriate it is and also assess senior manager’s understanding of **Because financial markets do not strictly conform to normal or the risk measures the firm is using.5 = accurate assessment of the risks you run.5%= Financial Markets Training 98. (standard deviation.000 on a $10m position).74% or $474. wwebster@barbicanconsulting. your VAR to be exceeded only 1 day in 100 days your regulator will not appreciate a frequency that exceeds this.uk Copyright © 2006 by BCL All rights reserved Financial Markets Training . Suppose you own a bond that has a price of 100% and you have calculated that the daily price volatility is 0.uk Put another way you are 99.000. reduced. So if you want to calculate the VAR with a 99.7%.00% and a 99. known to probe the methodology that is being used.50%.