Cascading bank notes

What is Value at Risk (VaR)?

If you invest in risky assets you need to monitor the level of risk you are exposed to. But how do you know if the level of risk associated with your investment exceeds what you are prepared to tolerate?

To monitor risk you can use a benchmark to indicate what the worst-case scenario could be regarding the potential losses for a single asset or for a portfolio of investments.

Value at Risk (VaR) provides a quantitative measure of risk in value with a given probability and within a defined period. The level of risk is summarised in a single number, which is then used as a benchmark when judging the level of risk the investor is exposed to.

For example, suppose the VaR on an asset is $100 million at a one-week 95% confidence level. This means that there is only a 5% chance that the value of the asset will drop more than $100 million over any given week. You will see how to calculate VaR in the next step.

Banks often use VaR to determine how much bank capital should be put aside. Bank regulators often ask banks to set aside a factor of the bank’s VaR as a capital requirement. Regulators consider that if the bank faces the level of risk indicated by the VaR within a defined period, then the bank should set aside 3-5 times of VaR as reserve capital for the same period. This way banks are prepared to respond to unexpected events.

So VaR has some clear advantages:

  • It captures an important aspect of risk in a single number, which can be understood by managers and regulators

  • VaR translates portfolio volatility into a dollar value

  • VaR is useful for monitoring and controlling risk within the portfolio

  • VaR can measure the risk of many types of financial securities (ie, stocks, bonds, commodities, foreign exchange, off-balance-sheet derivatives such as futures, forwards, swaps, and options, etc.)

However, VaR also has some weaknesses:

  • VaR does not adequately measure significant ‘events’ like market crashes. It estimates the possibility of large negative returns associated with securities and portfolios, but without taking into consideration the possible actions of other market participants. It assumes the volatility of returns, and the correlations between returns (how the returns vary in relation to each other), do not change.

  • VaR does not readily capture liquidity differences among instruments. Sharp and sudden falls in the prices of assets can put value at risk, but they can also reduce a bank’s liquidity. Shortage of liquidity has consequences for a bank’s ability to function and to meet its short-term liabilities. To make adequate preparation for this possibility, a bank should regularly compute estimates of value at risk, and also liquidity at risk.

Based on this explanation, do you see any connection between the use of VaR and the potential failure of risk management in practice?

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This article is from the free online course:

Risk Management in the Global Economy

SOAS University of London