16/12/2019 What Is the Parametric Method in Value at Risk (VaR)?

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What Is the Parametric Method in Value at

Risk (VaR)?

BY INVESTOPEDIA | Updated Feb 20, 2019

The parametric method, also known as the variance-covariance method, is a risk

management technique for calculating the value at risk (VaR) of a portfolio of assets.
The value at risk is a statistical risk management technique measuring the maximum loss
that an investment portfolio is likely to face within a specified time frame with a certain
degree of confidence. The variance-covariance method used to calculate the value at risk
identifies the mean, or expected value, and standard deviation of an investment portfolio.

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The parametric method looks at the price movements of investments over a look-back
period and uses probability theory to compute a portfolio's maximum loss. The variance-
covariance method for the value at risk calculates the standard deviation of price
movements of an investment or security. Assuming stock price returns and volatility follow
a normal distribution, the maximum loss within the specified confidence level is calculated.

One Security

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Consider a portfolio that includes only one security, stock ABC. Suppose $500,000 is invested
in stock ABC. The standard deviation over 252 days, or one trading year, of stock ABC, is 7%.
Following the normal distribution, the 95% confidence level has a z-score of 1.645. The value
at risk in this portfolio is $57,575 ($500000*1.645*.07). Therefore, with 95% confidence, the
maximum loss will not exceed $57,575 in a given trading year.

Two Securities
The value at risk of a portfolio with two securities can be determined by first calculating the
portfolio's volatility. Multiply the square of the first asset's weight by the square of the first
asset's standard deviation and add it to the square of the second asset's weight multiplied
by the square of the second asset's standard deviation. Add that value to two multiplied by
the weights of the first and second assets, the correlation coefficient between the two assets,
asset one's standard deviation, and asset two's standard deviation. Then multiply the square
root of that value by the z-score and the portfolio value.

For example, suppose a risk manager wants to calculate the value at risk using the
parametric method for a one-day time horizon. The weight of the first asset is 40%, and the
weight of the second asset is 60%. The standard deviation is 4% for the first and 7% for the
second asset. The correlation coefficient between the two is 25%. The z-score is -1.645. The
portfolio value is $50 million.

The parametric value at risk over a one-day period, with a 95% confidence level, is $3.99
million:

($50,000,000*-1.645)*√(0.4^2*0.04^2)+(0.6^2*0.07^2)+[2(0.4*0.6*0.25*0.04*0.07*)]

Multiple Assets
If a portfolio has multiple assets, its volatility is calculated using a matrix. A variance-
covariance matrix is computed for all the assets. The vector of the weights of the assets in
the portfolio is multiplied by the transpose of the vector of the weights of the assets
multiplied by the covariance matrix of all of the assets.

Financial Modeling
In practice, the calculations for VaR are typically done through financial models. Modeling
functions will vary depending on whether the VaR is being calculated for one security, two
securities, or a portfolio with three or more securities.

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Related Terms
Portfolio Variance Definition
Portfolio variance is the measurement of how the actual returns of a group of securities making up a
portfolio fluctuate. more

Using the Variance Equation

Variance is a measurement of the spread between numbers in a data set. Investors use the variance
equation to evaluate a portfolio's asset allocation. more

Market Risk Definition

Market risk is the possibility of an investor experiencing losses due to factors that affect the overall
performance of the financial markets. more

How Risk Analysis Works

Risk analysis is the process of assessing the likelihood of an adverse event occurring within the
corporate, government, or environmental sector. more

Value at Risk (VaR) Explained

Value at risk (VaR) is a statistic that measures and quantifies the level of financial risk within a firm,
portfolio, or position over a specific time frame. more

Understanding Beta and How to Calculate It

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the
market as a whole. Beta is used in the capital asset pricing model (CAPM). more

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