We will now learn how to calculate the VaR of one position and two positions by applying the concept of volatilities and correlations.
The following examples of how to calculate the risk of one and two positions illustrate the basic concept of parametric (delta) VaR estimation for linear instruments.
The general steps for calculating VaR are:
Step 1: Set VaR parameters: probability of loss and confidence level, time horizon, and base currency.
Step 2: Determine market value of each position, in base currency.
Step 3: Calculate VaR of individual positions, given market volatilities.
Step 4: Calculate portfolio VaR, given correlations between all variables.
VaR can be estimated as follows:
VaR = Market value X Price volatility
We will generally use the term volatility to express a multiple of standard deviation, depending on our chosen confidence level for VaR (i.e., confidence level multiple X standard deviation). Therefore, if we are using a VaR confidence level of 95%, volatility will refer to 1.65 X standard deviation.