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80-20 Rule

Application of VaR

Standard Deviation

Correlation Coefficient

Glossary

The most popular and traditional measure of risk isvolatility as it doesnt care about the

direction of an investment's movement.

For investors, risk is about the odds of losing money, and VaR is based on that common-sense

fact. By assuming investors care about the odds of a really big loss, VaR answers the

question, "What is my worst-case scenario?" or "How much could I lose in a really bad month?"

VaR statistic has three components: a time period, a confidence level and a loss amount (or

loss percentage). 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 - with a 95% or 99% level of confidence - expect to lose in dollars over the next month?

What is the maximum percentage I can - with 95% or 99% confidence - expect to lose over the next year?

You can see how the "VaR question" has three elements: a relatively high level of confidence

(typically either 95% or 99%), a time period (a day, a month or a year) and an estimate of

investment loss (expressed either in dollar or percentage terms).

financial risk within a firm over a specific time frame.

determine the extent and occurrence ratio of potential losses in their

institutional portfolios.

measure firm-wide risk exposure.

There are two methods to identifying VaR First is Historical Returns. The historical

method simply re-organizes actualhistorical returns, putting them in order from

worst to best.

The QQQ started trading in Mar 1999, and if we calculate each daily return, we

produce a rich data set of almost 1,400 points. For example, at the highest point of

the histogram, there were more than 250 days when the daily return was between

0% and 1%. At the far right, you can barely see a tiny bar at 13%; 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 12.4%!

Noticethe red bars. These are the lowest 5% of daily returns. The red bars run from

daily losses of 4% to 8%. Because these are the worst 5% of all daily returns, we can

say with 95% confidence that the worst daily loss will not exceed 4%. Put another

way, we expect with 95% confidence that our gain will exceed -4%. That is VAR in a

nutshell.

With95% confidence, we expect that our worst daily loss will not exceed

4%.

If we invest $100, we are 95% confident that our worst daily loss will not

exceed $4 ($100 x -4%).

You can see that VAR indeed allows for an outcome that is worse than a return of

-4%. It does not express absolute certainty but instead makes a probabilistic

estimate. To increase our confidence, we need only to "move to the left" on the

same histogram, to where the first two red bars, at -8% and -7% represent the

worst 1% of daily returns:

With 99% confidence, we expect that the worst daily loss will not exceed 7% or, if

we invest $100, we are 99% confident that our worst daily loss will not exceed $7.

The 80-20 is a ironclad rule that states that 80% of outcomes can be

recognized to 20% of all causes for a given event. In business, the 80-20 is

often used to point out that 80% of a company's revenue is generated by 20%

of its total customers. Therefore, the rule is used to help managers identify

and regulate which operating factors are most important and should receive

the most attention, based on an efficient use of resources.

STANDARD DEVIATION

thedistributionof a set of data from its mean.

If the data points are further from the mean,

there is higher deviation within the data set.

Standard deviation is calculated as the square

root of variance by determining the variation

between each data point relative to the mean.

is applied to the annualrate of returnof an

investment to measure the investment's

volatility. Standard deviation is a statistical

measurement that sheds light on

historical volatility. For example, a volatile

stock has a high standard deviation, while the

deviation of a stableblue-chipstock is lower. A

large dispersion indicates how much the return

on the fund is deviating from the expected

normal returns.

The Standard

deviation

DEVIATION

NORMAL CURVE

distribution, is theprobability distributionthat plots all of its values in a

symmetrical fashion, and most of the results are situated around the

probability's mean. Values are equally likely to plot either above or below the

mean. Grouping takes place at values close to the mean and then tails off

symmetrically away from the mean.

normally distributed. So it requires that we

estimate only two factors - an average return and

astandard deviation- which allow us to plot

anormal distributioncurve.

Confidenc

e

# of

Standard

Deviations(

)

95% (high)

- 1.65 x

99% (really

high)

- 2.33 x

2.64%. The average daily return happened to be

fairly close to zero, so we will assume an

average returnof zero for demonstrative

purposes. Here are the results of plugging the

actual standard deviation into the formulas

above:

to the ideas behind the historical method - except

that we use the familiar curve instead of actual

data. The advantage of the normal curve is that

we automatically know where the worst 5% and 1%

lie on the curve. They are a function of our

desired confidence and the standard deviation ():

Confidenc

e

# of

Calculatio

n

Equals

95% (high)

- 1.65 x

- 1.65 x

(2.64%) =

-4.36%

99% (really

- 2.33 x

high)

- 2.33 x

(2.64%) =

-6.15%

two variables movements are associated.

If a calculated correlation is greater than 1.0 or less than -1.0, a mistake has

been made.

correlation of 1.0 indicates a perfectpositive correlation.

COEFFICIENT

VAR is just one numbergiving you arough ideaabout theextent of risk in the portfolio. Value At Risk is

measured in price units(dollars, euros) or aspercentage of portfolio value. This makes VAR very easy to

interpret and to further use in analyses, which is one of the biggestadvantages of Value At Risk.

You can measure andcompare VAR of different types of assetsand various portfolios. Value At Risk is

applicable to stocks, bonds, currencies, derivatives, or any other assets with price. This is why banks

and financial institutions like it so much they cancompare profitability and risk of different unitsand

allocate risk based on VAR (this approach is calledrisk budgeting).

Value At Riskis a frequent part ofvarious types of financial software. For example, you can

quicklycalculate Value At Riskof your portfolio on Bloomberg after entering holdings and setting a few

parameters. You dont have to be a statistics wizard to do this, as the software takes historical data of

securities in the portfolio and performs all calculations for you. Availability is a bigadvantage of VAR.

APPLYING VaR

Investment banks commonly apply VaR modeling to firm-wide risk due to the

possibility for independent trading desks to expose the firm to highly

correlated assets unintentionally.

increasing risks from combined positions held by different trading desks and

departments within the organization.

determine whether they have adequate capital reserves in place to cover

losses or whether higher-than-acceptable risks need focused on holdings to be

reduced.

Ignores the fact that some markets converge with time or have patterns, such as mean

reversion

Based on historical information (i.e. assumes that history will repeat itself)

Ignores the 0key risk associated with our hard assets (e.g. mines, mills, plants)

QUESTIONS

GLOSSARY

period. Generally, this measure is calculated by determining the average deviation from

the average price of afinancialinstrument in the given time period.

expressed as a percentage of theinvestment'scost. Gains on investments are definedas

income received plus any capital gains realized on the sale of the investment.

historical return data when trying to predict future returns, or to estimate how a

security might react to a particular situation, such as a drop in consumer demand.

Historical returns can also be useful when estimating where future points of data may

fall in terms ofstandard deviations.

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