How is VaR calculated?
It depends on the method used, variance/covariance, Monte Carlo, historical simulation. Generally, it involves using historical data on market prices and rates, the current portfolio positions, and models (e.g., option models, bond models) for pricing those positions. These inputs are then combined in different ways, depending on the method, to derive an estimate of a particular percentile of the loss distribution, typically the 99th percentile loss.
While investors pay a percentage margin, the actual VaR calculation is a lot more complex. There are three kinds of risks associated with a stock or index, namely price risk, credit risk and liquidity risk. VaR tries to quantify these three types of risks. For price risk, it considers portfolio losses arising out of market price fluctuations in the past, credit risk (track record of defaults) and liquidity risk (impact cost in the past). However, given the difficulty in working out a model to measure liquidity risk and credit risk that would apply fairly to all stocks, most exchanges tend to work out the VaR on the basis of just the price risk. For this, volatility models are used. This entails calculating standard deviation of a time series of daily portfolio profits and losses. Standard deviation provides a measurement of volatility of the past returns, which is then used as a probability estimate in the form of a VaR. Advantage VaR. At present, the initial margin (in percentage term
