What is VaR?
Value at risk (VaR) has been the flavor of the month in risk management circles recently. The idea of a VaR type calculation was originally stimulated by the requests from senior management in financial institutions for a simpler risk report. (“Just one number — I only want to see one number that tells me how bad things can get.”) Much of the interest in VaR has been stimulated by the fact that under an agreement reached by the Bank for International Settlements, all bank regulators now require that banks calculate the VaR for their trading portfolios. The regulatory capital required for these portfolios is then based on the calculated VaR.1 Here we will provide a simple explanation of what VaR is and how it is calculated. Then we will discuss the difficulties that are likely to be encountered in implementing a VaR system. Finally, we will explore the circumstances under which VaR is useful and when it is not likely to be of much value. How to Calculate VaR The official definition of
I think of Value at Risk as a measure of potential loss from an unlikely, adverse event in a normal, everyday market environment. VaR is denominated in units of a currency, e.g., US dollars. To get more concrete, VaR is an amount, say D dollars, where the chance of losing more than D dollars is, say, 1 in 100 over some future time interval, say 1 day. This is a probabilistic statement, and therefore VaR is a statistical measure of risk exposure. The calculation of VaR requires the application of statistical theory.
