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



This article is mainly focused on RISKS (VaR) in INVESTMENTS. 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 worstcase scenario?" or A VaR statistic has three components: (a) A time period 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? 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 2. VarianceCovariance Method 3. Monte Carlo Simulation Method (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. 



Source : Email December 23, 2004 

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