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.
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.
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.