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# Value at risk

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The 5% Value at Risk of a hypothetical profit-and-loss probability density function In financial mathematics and financial risk management, Value at Risk (VaR) is a 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 the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.[1] For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 0.05 probability that the portfolio will fall in value by more than $1 million over a one day period if there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day in 20. A loss which exceeds the VaR threshold is termed a “VaR break.”[2] Thus, VaR is a piece of jargon favored in the financial world for a percentile of the predictive probability distribution for the size of a future financial loss. VaR has five main uses in finance: risk management, financial control, financial reporting and computing regulatory capital. VaR is sometimes used in non-financial applications as well.[3] Important related ideas are economic capital, backtesting, stress testing, expected shortfall, and tail conditional expectation.[4]

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Common parameters for VaR are 1% and 5% probabilities and one day and two week horizons, although other combinations are in use.[5]

This generally does not lead to confusion because the probability of VaR breaks is almost always small. Therefore the end-of-period definition is the most common both in theory and practice today. one used primarily in risk management and the other primarily for risk measurement. It is also easier theoretically to deal with a point-in-time estimate versus a maximum over an interval. and sometimes as the maximum loss at any point during the period. and there is no distinction between VaR breaks caused by input errors (including Information Technology breakdowns.[7] Another inconsistency is VaR is sometimes taken to refer to profit-and-loss at the end of the period.[1] Although it virtually always represents a loss.The reason for assuming normal markets and no trading. This claim is validated by a backtest. loss of market confidence and employee morale and impairment of brand names can take a long time to play out. VaR is a system.[10] To a risk manager. and to restricting loss to things measured in daily accounts. computation errors (including failure to produce a VaR on time) and market movements. all that can be said is that they will not do so very often. financial reporting and computing regulatory capital. certainly less than 0. VaR marks the boundary between normal days and extreme events. there is wide scope for interpretation in the definition.5. so that the VaR in the example above would be called a one-day 95% VaR instead of oneday 5% VaR. There is never any subsequent adjustment to the published VaR. As people began using multiday VaRs in the second half of the 1990s they almost always estimated the distribution at the end of the period only. The distinction is not sharp. Moreover.[11] A frequentist claim is made. that the long-term frequency of VaR breaks will equal the specified probability. A negative VaR would imply the portfolio has a high probability of making a profit.[8] Varieties of VaR The definition of VaR is nonconstructive. a comparison of . The system is run periodically (usually daily) and the published number is compared to the computed price movement in opening positions over the time horizon.[6] The probability level is about equally often specified as one minus the probability of a VaR break. In some extreme financial events it can be impossible to determine losses. for example a one-day 5% VaR of negative $1 million implies the portfolio has a 5% chance of making more than $1 million over the next day. and that the VaR breaks will be independent in time and independent of the level of VaR. and hybrid versions are typically used in financial control. and may be hard to allocate among specific prior decisions. but not how to compute VaR. within the limits of sampling error. but in the early 1990s when VaR was aggregated across trading desks and time zones. Some longer-term consequences of disasters. The original definition was the latter. not a number. it specifies a property VaR must have. end-of-day valuation was the only reliable number so the former became the de facto definition. VaR is conventionally reported as a positive number.[9] This has led to two broad types of VaR. such as lawsuits. fraud and rogue trading). however. is to make the loss observable. Institutions can lose far more than the VaR amount. either because market prices are unavailable or because the loss-bearing institution breaks up.

that given the information and beliefs at the time. Rather than comparing published VaRs to actual market movements over the period of time the system has been in operation. VaR is retroactively computed on scrubbed data over as long a period as data are available and deemed relevant. if a trading desk is held to a VaR limit.published VaRs to actual price movements. most of the recent ones seem to agree that risk management VaR is superior for making short-term and tactical decisions today. For example. if of the level -quantile. VaR is adjusted after the fact to correct errors in inputs and computation. and an input into the risk measurement computation of the desk’s risk-adjusted return at the end of the reporting period. i. but not to incorporate information unavailable at the time of computation. and pension plans. while risk measurement VaR should be used for understanding the past. Essentially trustees adopt portfolio Values-at-Risk metrics for the entire pooled account and the diversified parts individually managed. Doing so provides an easy metric for oversight and adds accountability as managers are then directed to manage.[7] In this context. VaR utilized in this manner adds relevance as well as an easy to monitor risk measurement control far more intuitive than Standard Deviation of Return. The same position data and pricing models are used for computing the VaR as determining the price movements. trusts. and making medium term and strategic decisions for the future.[1] For risk measurement a number is needed.[4] VaR in Governance An interesting takeoff on VaR is its application in Governance for endowments. that is both a risk-management rule for deciding what risks to allow today. as well as a worthwhile critique on board governance practices as it relates to investment management oversight in general can be found in 'Best Practices in Governance". the subjective probability of a VaR break was the specified level.e. is the return of a portfolio. Use of VaR in this context. When VaR is used for financial control or financial reporting it should incorporate elements of both. Instead of probability estimates they simply define maximum levels of acceptable loss for each.[2] Although some of the sources listed here treat only one kind of VaR as legitimate.[12] Mathematical definition "Given some confidence level the VaR of the portfolio at the confidence level is given by the smallest number such that the probability that the loss exceeds is not larger than "[3] Mathematically. In this interpretation. “backtest” has a different meaning. but wide disagreements on daily VaR values. then the is the negative [13] . A Bayesian probability claim is made. not a system. many different systems could produce VaRs with equally good backtests. but with the additional constraint to avoid losses within a defined risk parameter.

mean absolute deviation. Instead of mark-to-market. some risk measures incorporate the effect of expected trading (such as a stop loss order) and consider the expected holding period of positions. later sources are more likely to emphasize the metric. Risk managers typically assume that some fraction of the bad events will have undefined losses. For example. impairment of brand names or lawsuits. This sometimes leads to confusion.[4] Rather than assuming a fixed portfolio over a fixed time horizon. either because markets are closed or illiquid. In 1997.[1] This point has probably caused more contention among VaR theorists than any other. which uses market prices to define loss. such as loss of market confidence or employee morale. The right equality assumes an underlying probability distribution. Or we could try to incorporate the economic cost of things not measured in daily financial statements.[9] VaR can also be written as a distortion risk measure given by the distortion function [15][16] Risk measure and risk metric The term “VaR” is used both for a risk measure and a risk metric. Finally.[6] Nassim Taleb has labeled this assumption."[14] On the other hand. Philippe Jorion wrote:[17] . There are many alternative risk measures in finance. "charlatanism. The VaR risk measure defines risk as mark-to-market loss on a fixed portfolio over a fixed time horizon. many academics prefer to assume a well-defined distribution. rather than excluding them from the computation.[4] The VaR risk metric summarizes the distribution of possible losses by a quantile. Sources earlier than 1995 usually emphasize the risk measure. Common alternative metrics are standard deviation. some systems do not recognize a loss. or because the entity bearing the loss breaks apart or loses the ability to compute accounts. they do not accept results based on the assumption of a well-defined probability distribution.[1] VaR risk management Supporters of VaR-based risk management claim the first and possibly greatest benefit of VaR is the improvement in systems and modeling it forces on an institution. a point with a specified probability of greater losses. which makes it true only for parametric VaR.The left equality is a definition of VaR. assuming normal markets. if an institution holds a loan that declines in market price because interest rates go up. expected shortfall and downside risk. albeit usually one with fat tails. some risk measures adjust for the possible effects of abnormal markets. Therefore. but has no change in cash flows or credit quality. loss is often defined as change in fundamental value.

Institutions should be confident they have examined all the foreseeable events that will cause losses in this range. and to survive the loss if not.[19] Outside the VaR limit. Inside the VaR limit. One to three times VaR are normal occurrences. If they do they should be hedged or insured.[21] Knowing the distribution of losses beyond the VaR point is both impossible and useless. or the business plan should be changed to avoid them. Publishing a daily number. Probability estimates are meaningful. Institutions that go through the process of computing their VAR are forced to confront their exposure to financial risks and to set up a proper risk management function. there is no true risk because you have a sum of many independent observations with a left bound on the outcome. as do data feeds that are inaccurate or late and systems that are too-frequently down. A casino doesn't worry about whether red or black will come up on the next roulette spin. loss of employee morale and market confidence and impairment of brand names. and you might get more than one break in a short period of time.[22] 1. because they are out of scale with daily experience. In a sense. because they happen frequently. Of course there will be unforeseeable . so risk/return calculations are useless. You expect periodic VaR breaks.[20] Probability statements are no longer meaningful. It's hard to plan for these events.[1] One specific system uses three regimes. but an institution that cannot compute VaR will not. Thus the process of getting to VAR may be as important as the number itself. People tend to worry too much about these risks. markets may be abnormal and trading may exacerbate losses. Foreseeable events should not cause losses beyond ten times VaR. because there are enough data to test them. conventional statistical methods are reliable. and not enough about what might happen on the worst days. The loss distribution typically has fat tails. So an institution that can't deal with three times VaR losses as routine events probably won't survive long enough to put a VaR system in place. “A risk-taking institution that does not compute VaR might escape disaster. Moreover. Anything that affects profit and loss that is left out of other reports will show up either in inflated VaR or excessive VaR breaks. These events are too rare to estimate probabilities reliably.[T]he greatest benefit of VAR lies in the imposition of a structured methodology for critically thinking about risk. It's hard to run a business if foreseeable losses are orders of magnitude larger than very large everyday losses. modeled or priced incorrectly stand out. Positions that are reported. Three to ten times VaR is the range for stress testing. The risk manager should concentrate instead on making sure good plans are in place to limit the loss if possible. Risk managers encourage productive risk-taking in this regime. because there is little true cost. and are prepared to survive them. and you may take losses not measured in daily marks such as lawsuits. or VaR should be increased.” [18] The second claimed benefit of VaR is that it separates risk into two regimes. Relatively short-term and specific data can be used for analysis. on-time and with specified statistical properties holds every part of a trading organization to a high objective standard. 3. all bets are off. Risk should be analyzed with stress testing based on longterm and broad market data. Robust backup systems and default assumptions must be implemented. 2.

and many financial businesses mark-to-market daily. but it's pointless to anticipate them. Better to hope that the discipline of preparing for all foreseeable three-to-ten times VaR losses will improve chances for surviving the unforeseen and larger losses that inevitably occur. Individual business units have risk measures such as duration for a fixed income portfolio or beta for an equity business.[18] The probability level is chosen deep enough in the left tail of the loss distribution to be relevant for risk decisions. such as positions marked in different time zones. variance-covariance VaR or deltagamma VaR) or nonparametrically (for examples. that it called the entire basis of quant finance into question. expected shortfall and “greeks” (partial derivatives of portfolio value with respect to market factors). Retrospective analysis has found some VaR-like concepts in this history. "A risk manager has two jobs: make people take more risk the 99% of the time it is safe to do so. investment management and derivative pricing. that overwhelmed the statistical assumptions embedded in models used for trading. it is natural to define firm-wide risk using the distribution of possible losses at a fixed point in the future. VaR is usually reported alongside other risk metrics such as standard deviation. and survive the other 1% of the time.[4][6] Nonparametric methods of VaR estimation are discussed in Markovich [24] and Novak. or a high frequency trading desk with a business holding relatively illiquid positions."[18] VaR risk measurement The VaR risk measure is a popular way to aggregate risk across an institution.[25] History of VaR The problem of risk measurement is an old one in statistics. But VaR did not emerge as a distinct concept until the late 1980s. Financial risk management has been a concern of regulators and financial executives for a long time as well. you can't know much about them and it results in needless worrying. VaR is the border.losses more than ten times VaR. including ones that were usually not correlated. These affected many markets at once. and seldom had . historical simulation VaR or resampled VaR). economics and finance.[4] In risk measurement.[23] VaR can be estimated either parametrically (for example. but not so deep as to be difficult to estimate with accuracy. These cannot be combined in a meaningful way. This was the first major financial crisis in which a lot of academically-trained quants were in high enough positions to worry about firm-wide survival. A reconsideration of history led some quants to decide there were recurring crises.[1] It is also difficult to aggregate results available at different times. about one or two per decade.[1] The crash was so unlikely given standard statistical models. that is it does not depend on assumptions about the probability distribution of future gains and losses. But since every business contributes to profit and loss in an additive fashion. The triggering event was the stock market crash of 1987. VaR is a distribution-free metric.

[19] It is not always possible to define loss if. in non-obvious ways.[26] If these events were included in quantitative analysis they dominated results and led to strategies that did not work day to day. the methodology was spun off into an independent for-profit business now part of RiskMetrics Group. although neither the name nor the definition had been standardized. Securities and Exchange Commission ruled that public corporations must disclose quantitative information about their derivatives activity. P.[18] Losses can also be hard to define if the risk-bearing institution fails or breaks up. can lead to self reference. they were named "Black Swans" by Nassim Taleb and the concept extended far beyond finance.[21] Much later. The extent to which this has proven to be true is controversial. available within 15 minutes of the market close. or severely illiquid.[21] The financial events of the early 1990s found many firms in trouble because the same underlying bet had been made at many places in the firm. Two years later. If these events were excluded. Major banks and dealers chose to implement the rule by including VaR information in the notes to their financial statements. This was the first time VaR had been exposed beyond a relatively small group of quants.[9] In 1997. Morgan. Since many trading desks already computed risk management VaR. notably Bankers Trust. Morgan CEO Dennis Weatherstone famously called for a “4:15 report” that combined all firm risk on one page. Development was most extensive at J. it was the natural choice for reporting firmwide risk.S. It was well established in quantitative trading groups at several financial institutions. markets are closed as after 9/11. which are studied quantitatively using short-term data in specific markets. the U.[1] . which are studied qualitatively over long-term history and broad market events. from everyday price movements.discernible economic cause or warning (although after-the-fact explanations were plentiful). and avoiding other actions. as happened several times in 2008. Institutions could fail as a result.[19] A measure that depends on traders taking certain actions.[18][21][26] VaR was developed as a systematic way to segregate extreme events.[21] Abnormal markets and trading were excluded from the VaR estimate in order to make it observable. J. It was hoped that "Black Swans" would be preceded by increases in estimated VaR or increased frequency of VaR breaks. which published the methodology and gave free access to estimates of the necessary underlying parameters in 1994. P. the profits made in between "Black Swans" could be much smaller than the losses suffered in the crisis. before 1990.[1] This is risk management VaR. for example.[9] Risk measurement VaR was developed for this purpose. and it was the only common risk measure that could be both defined for all businesses and aggregated without strong assumptions. in at least some markets. There was no effort to aggregate VaRs across trading desks.

it should insure against it and take advice from insurers on precautions.500 years of experience in favor of untested models built by non-traders 2. Gave false confidence 4. Taleb claimed VaR:[27] 1. After interviewing risk managers (including several of the ones cited above) the article suggests that VaR was very useful to risk experts. 2.0004% chance of being robbed on a specific day. A powerful tool for professional risk managers. Would be exploited by traders More recently David Einhorn and Aaron Brown debated VaR in Global Association of Risk Professionals Review[18][28] Einhorn compared VaR to “an airbag that works all the time. 4. beginning in 1999 and nearing completion today. the risk of a robbery on a specific day rises to within an order of magnitude of VaR. For example. the average bank branch in the United States is robbed about once every ten years. A single-branch bank has about 0. Ignored 2. A common complaint among academics is that VaR is not subadditive. A famous 1997 debate between Nassim Taleb and Philippe Jorion set out some of the major points of contention. VaR is the preferred measure of market risk. At that point it makes sense for the institution to run internal stress tests . 2009 discussing the role VaR played in the Financial crisis of 2007-2008. so it is in the range where the institution should not worry about it. As institutions get more branches. gave further impetus to the use of VaR. It would not even be within an order of magnitude of that. VaR is portrayed as both easy to misunderstand. and dangerous when misunderstood. and concepts similar to VaR are used in other parts of the accord. so the risk of robbery would not figure into one-day 1% VaR.” He further charged that VaR: 1. except when you have a car accident.Worldwide adoption of the Basel II Accord. To a practising risk manager this makes sense. It does not pay for a onebranch bank to have a security expert on staff. Was charlatanism because it claimed to estimate the risks of rare events. Led to excessive risk-taking and leverage at financial institutions Focused on the manageable risks near the center of the distribution and ignored the tails Created an incentive to take “excessive but remote risks” Was “potentially catastrophic when its use creates a false sense of security among senior executives and watchdogs. which is impossible 3.” New York Times reporter Joe Nocera wrote an extensive piece Risk Mismanagement[29] on January 4. but nevertheless exacerbated the crisis by giving false security to bank executives and regulators.[4] That means the VaR of a combined portfolio can be larger than the sum of the VaRs of its components. 3.[1] Criticism VaR has been controversial since it moved from trading desks into the public eye in 1994. The whole point of insurance is to aggregate risks that are beyond individual VaR limits. and bring them into a large enough portfolio to get statistical predictability.

however. A sizable in-house security department is in charge of prevention and control. 3. The main problem with volatility. and sometimes impossible to define. To a risk manager. Making VaR control or VaR reduction the central concern of risk management. to inside VaR. Risk Management Value at risk (VAR or sometimes VaR) has been called the "new science of risk management". Futures. but you do not need to be a scientist to use VAR. That means they move from the range of far outside VaR. often three. For a very large banking institution. Forwards. A common specific violation of this is to report a VaR based on the unverified assumption that everything follows a multivariate normal distributio An Introduction To Value at Risk (VAR) May 27 2010 | Filed Under » Financial Theory.[18] Even VaR supporters generally agree there are common abuses of VaR:[6][9] 1.and analyze the risk itself. once you get beyond the VaR point. Assuming plausible losses will be less than some multiple. The entire point of VaR is that losses can be extremely large. to be analyzed case-by-case. we look at the idea behind VAR and the three basic methods of calculating it. and tracked statistically rather than case-by-case. As portfolios or institutions get larger. VaR is the level of losses at which you stop trying to guess what will happen next. Here. It is far more important to worry about what happens when losses exceed VaR. to be insured. in part 1 of this series. robberies are a routine daily occurrence. It will spend less on insurance and more on in-house expertise. of VaR. Regardless of how VaR is computed. to near outside VaR. Reporting a VaR that has not passed a backtest. Referring to VaR as a "worst-case" or "maximum tolerable" loss. the general risk manager just tracks the loss like any other cost of doing business. In Part 2. Options. Losses are part of the daily VaR calculation. is that it does not care about the direction of an investment's movement: a stock can be . 2. we apply these methods to calculating VAR for a single stock or investment. The Idea behind VAR The most popular and traditional measure of risk is volatility. it should have produced the correct number of breaks (within sampling error) in the past. In fact. and start preparing for anything. to be treated statistically. 4. specific risks change from low-probability/lowpredictability/high-impact to statistically predictable losses of low individual impact. you expect two or three losses per year that exceed one-day 1% VaR.

putting them in order from worst to best. investors are not distressed by gains! (See The Limits and Uses of Volatility. There are three methods of calculating VAR: the historical method.Article continues below. At the far right.with 95% or 99% confidence . we produce a rich data set of almost 1. Keep these three parts in mind as we give some examples of variations of the question that VAR answers: What is the most I can . risk is about the odds of losing money. Methods of Calculating VAR Institutional investors use VAR to evaluate portfolio risk.000 Practice Account . A VAR statistic has three components: a time period. It then assumes that history will repeat itself. but in this introduction we will use it to evaluate the risk of a single index that trades like a stock: the Nasdaq 100 Index. By assuming investors care about the odds of a really big loss. Let's put them in a histogram that compares the frequency of return "buckets". and if we calculate each daily return. VAR answers the question. you can barely see a tiny bar at 13%. The QQQQ is a very popular index of the largest non-financial stocks that trade on the Nasdaq exchange. a confidence level and a loss amount (or loss percentage). there were more than 250 days when the daily return was between 0% and 1%.) For investors. The QQQ started trading in Mar 1999. which trades under the ticker QQQQ. "What is my worst-case scenario?" or "How much could I lose in a really bad month?" Now let's get specific. You can see how the "VAR question" has three elements: a relatively high level of confidence (typically either 95% or 99%). from a risk perspective. 1.4%! FXCM -Online Currency Trading Free $50.with a 95% or 99% level of confidence . the variance-covariance method and the Monte Carlo simulation. a time period (a day. at the highest point of the histogram (the highest bar).expect to lose in dollars over the next month? What is the maximum percentage I can . it represents the one single day (in Jan 2000) within a period of five-plus years when the daily return for the QQQ was a stunning 12.volatile because it suddenly jumps higher. a month or a year) and an estimate of investment loss (expressed either in dollar or percentage terms).400 points. and VAR is based on that common-sense fact. Of course. Historical Method The historical method simply re-organizes actual historical returns. For example.expect to lose over the next year? Advertisement .

we expect that our worst daily loss will not exceed 4%. we can say with 95% confidence that the worst daily loss will not exceed 4%. If we invest $100. if we invest $100. Put another way. It does not express absolute certainty but instead makes a probabilistic estimate. In other words. These are the lowest 5% of daily returns (since the returns are ordered from left to right. That is VAR in a nutshell. it requires that we estimate only two factors . we expect that the worst daily loss will not exceed 7%. we are 95% confident that our worst daily loss will not exceed $4 ($100 x -4%). Or. The red bars run from daily losses of 4% to 8%. we expect with 95% confidence that our gain will exceed -4%. Let's re-phrase the statistic into both percentage and dollar terms: With 95% confidence.which allow us to plot a normal distribution curve. If we want to increase our confidence. at -8% and -7% represent the worst 1% of daily returns: With 99% confidence. You can see that VAR indeed allows for an outcome that is worse than a return of -4%. Because these are the worst 5% of all daily returns.Notice the red bars that compose the "left tail" of the histogram. we are 99% confident that our worst daily loss will not exceed $7.an expected (or average) return and a standard deviation . 2. we need only to "move to the left" on the same histogram. to where the first two red bars. the worst are always the "left tail"). Here we plot the normal curve against the same actual return data: . The Variance-Covariance Method This method assumes that stock returns are normally distributed.

The advantage of the normal curve is that we automatically know where the worst 5% and 1% lie on the curve.The idea behind the variance-covariance is similar to the ideas behind the historical method except that we use the familiar curve instead of actual data. Here are the results of plugging the actual standard deviation into the formulas above: 3. They are a function of our desired confidence and the standard deviation ( ): The blue curve above is based on the actual daily standard deviation of the QQQ. A Monte Carlo simulation refers to any method that randomly generates trials. For most users. Without going into further details. so we will assume an average return of zero for illustrative purposes. we ran a Monte Carlo simulation on the QQQ . a Monte Carlo simulation amounts to a "black box" generator of random outcomes. but by itself does not tell us anything about the underlying methodology.64%. which is 2. Monte Carlo Simulation The third method involves developing a model for future stock price returns and running multiple hypothetical trials through the model. The average daily return happened to be fairly close to zero.

and three were between -20% and 25%.asp#ixzz1tGR5JYrP . Among them. If we ran it again. That means the worst five outcomes (that is. In Part 2 of this series we show you how to compare these different time horizons. we ran 100 hypothetical trials of monthly returns for the QQQ.investopedia. The Monte Carlo simulation therefore leads to the following VAR-type conclusion: with 95% confidence. 100 trials were conducted. But keep in mind that two of our methods calculated a daily VAR and the third method calculated monthly VAR. Summary Value at Risk (VAR) calculates the maximum loss expected (or worst case scenario) on an investment.based on its historical trading pattern. the worst 5%) were less than -15%. over a given time period and given a specified degree of confidence.com/articles/04/092904. we do not expect to lose more than 15% during any given month. two outcomes were between -15% and -20%. We looked at three methods commonly used to calculate VAR. In our simulation. this graph displays monthly returns): To summarize. Read more: http://www. we would get a different result--although it is highly likely that the differences would be narrow. Here is the result arranged into a histogram (please note that while the previous graphs have shown daily returns.