Value at Risk (VaR) – A bird's eye view


Author (s)

M. Subramanian
Faculty in Finance
Institute for Technology & Management
Chennai

R. Swarnasiyamala Subramanian
Chennai-26

Dr. A. Venkatachalam
Reader
PG Commerce Dept, SVN College
Madurai

Cell: 09443929922
Email:
financesubbuu@rediffmail.com / madurai_subbu@yahoo.co.in
 


Introduction

This article is mainly focused on RISKS (VaR) in INVESTMENTS.
There is no need to say that today's world is highly dynamic and this particular factor leads to change in situation / environment (internal & external); this change could be either fierce or peace. What ever be the phenomenon the 'fierce' factor, technically called as "RISK", is much of talked about all times.  Is there any way to have a foolproof risk shield? The answer is obvious NO. The fact is you could reduce the degree of risk but you can't eliminate it fully. The risk factor is like 'diabetic' in human body; once a human being is affected by diabetic, there is no cure but you can control to the best possible extent by your food habits & regular exercise, with proper medicines. The same fact applies to risk.

What is RISK?

Risk can be termed as any variation from the expected level of performance/outcome. The risk factor could be estimated by applying the probability factor to the future events, which are supposed to happen.  There are ample numbers of ways to estimate the future events; the ways to estimate the future events differs from organization to organization, individuals to individuals. Risk can be basically classified into two types, namely: Controllable Risk & Uncontrollable Risk. You can only reduce the effect of controllable risk, but not the uncontrollable part. Based on this premise only we have submitted our views in the introduction part.

Discussion – Why, yet again, a new method of calculating risk?

Instead of calculating risk factor from traditional methods (like volatility), either by standard deviation or by beta factor or any other methods, this new science of risk management called "Value at Risk" makes more sense. The main problems in the traditional methods are: It does not care about the direction of an investment's movement: a stock can be volatile because it suddenly humps higher. But investors are not distressed by gains.  But VaR makes an attempt to address these problems. It checks the direction of investment and based on that we do the further value analysis on our investments.

What is Value at Risk? (VaR) & what are the basic components of VaR?

For investors, risk is about the odds of losing money, and VaR is based on that common sense. VaR is widely used by institutional investors. By assuming investors care about the odds of a really big loss, VaR answers the question:

"What is my worst-case scenario?" or
"How much could I lose in a really bad month?".

A VaR statistic has three components:

(a) A time period
(b) A confidence level
(c) A loss amount (or loss %)

Conceptual Example – Explanation of VaR

Keep these three (time, confidence level & loss) parts in mind as the following examples of variations of the question that VaR answers:

(a) What is the most I can – with 95% or 90% level of confidence – expect to lose in money value over the next month?
(b) What is the maximum % I can – with 95% or 99% level of confidence – expect to lose over the next year?

You can see how the "VaR question" has three elements: a relatively high level of confidence (typically 95% or 99%), a time period (a day, a month, or a year), and an estimate of investment loss (expressed either in money value or in % terms).

Types of Calculating VaR

1. Historical Method
    (Uses Histogram)

2. Variance-Covariance Method
    (Uses Normal Distribution)

3. Monte Carlo Simulation Method
   (Uses Simulation)

(Discussion in detail about the types of calculating VaR is out of scope of this article. This article aims at giving a birds eye view about VaR to investors & readers)

Conclusion

VaR calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence.
 


M. Subramanian
Faculty in Finance
Institute for Technology & Management
Chennai

R. Swarnasiyamala Subramanian
Chennai-26

Dr. A. Venkatachalam
Reader
PG Commerce Dept, SVN College
Madurai

Cell: 09443929922
E-mail:
financesubbuu@rediffmail.com / madurai_subbu@yahoo.co.in
 

Source : E-mail December 23, 2004

 

B A C K

 

Important Note :
Site Best Viewed in Internet
Explorer in 1024x768 pixels
Browser text size: Medium