Value at Risk (VaR)

Define the concept of Value-at-Risk (VaR)

Value-at- Risk (VaR) is a general measure of risk developed to equate risk across products and to aggregate risk on a portfolio basis. VaR is defined as the predicted worst-case loss with a specific confidence level (for example, 95%) over a period of time (for example, 1 day). For example, every afternoon, J.P. Morgan takes a snapshot of its global trading positions to estimate its DEaR (Daily-Earnings-at-Risk), which is a VaR measure defined as the 95% confidence worst-case loss over the next 24 hours due to adverse price moves.

Multiple Levels

The elegance of the solution is that it works on multiple levels, from the position-specific micro level to the portfolio-based macro level. VaR has become a common language for communication about aggregate risk taking, both within an organization and outside (for example, with analysts, regulators, and shareholders).

Benefits of VaR

  • Measures risk, not notional exposure--relates risk to capacity
  • Provides comparable risk measure across business groups
  • Facilitates aggregation of risk--portfolio effects
  • Can compare risk to daily profit and loss (P&L)--reality check
  • Facilitates stress testing--hidden concentration

Four Basic Questions

A VaR system seeks to answer:

1. How much can I lose? - Bottom line focus

2. Where would losses be concentrated? - Measure concentration by business group, region and risk type.

3. Which exposures offset each other? - highlight offsetting positions or hedges and diversifications.

4. How much return to expect? - Target appropriate return for risk taken.

Time Horizon

The application of the VaR concept is a fundamental component of the RiskMetrics® framework. A VaR of USD 100 means that on average, only 1 day in 20 would you expect to lose more than USD 100 due to market movements.

This definition of VaR uses a 5% risk level: You would anticipate exceeding your VaR amount only 5% of the time (or, 95% of the time you expect to lose less than your VaR amount) over a 1-day horizon.