I’ve invested in some assets or securities but as a smart investor, I should be aware of the risk inherited in securities. So the best way to measure a risk is VaR (Value at risk). By measuring the VaR you will be known of how much % of asset is at risk. For example- If the VaR @ 95% is $1million it means there is 95% probability that your loss will be lower than $1 million for the given security. It comes under valuation and risk model of FRM-I which comprises of 30% weightage in the exam.

VaR in brief:-
“Life is all about management of risk, not its elimination” - Walter Wriston, former chairman of CitiCorp
As has been truly stated by ex – chairman of CitiCorp, it is practically impossible to eliminate the risk, but efforts can always be made to alleviate it to the maximum extent possible. In this session, we will understand the basic idea behind VaR and the associated methodology for VaR computations.

Traditionally, we have been using volatility as a measure of risk in our portfolios. However, the issue with the usage of volatility as a measure of risk is that it does not care about the direction in which an investment moves. For example, if suddenly most of the stocks rise in value one day, then your portfolio will reap huge profits. Here again, the stock is referred to as volatile.

But, are we not happy with this kind of volatility??

Yes!! We are. But we are mainly concerned about the downside potential of our investments/portfolio or the “worst – case” scenario that can happen in a given month or a year. This is exactly where VaR as a measure of risk comes to limelight.
VaR basically addresses the below concerns of an investor:
  • What is the most I can expect to lose in dollars over the period of next one month- with a 95% or 99% level of confidence?
  • What is the maximum percentage I can - with 95% or 99% confidence - expect to lose over the next year?

This implies that a VaR approach has three elements namely:
  • A designated time period (a day, one month, one year etc)
  • A relatively high level of confidence (typically 95%, 98% etc)
  • An estimate of portfolio losses (expressed in either dollar or percentage terms)

  • The computation of regulatory capital is based upon VaR calculations.
  • It provides senior management (Risk Managers) with a simple and effective way to monitor risk.
  • VaR uses historical data/history to predict near term future.
  • It is applicable mainly to trading portfolios.
Interpreting VaR
Say the 95% daily VAR of your assets is $300, then it means that out of those 100 days there would be 95 days when your daily loss would be less than $300. This implies that during 5 days you may lose more than $300 daily. But out of those five days, there may be a day where the losses might be >$10000!!

This is one of the shortcomingsof VaR as a measure of risk (as discussed below).
Failure of VaR as a Risk Measure
  • It does not tell us about the extent to which we can lose. It only tells us that the losses can be greater than a particular number. But it is silent on the exact amount of potential loss.
  • Pro cyclical effect of VaR on Risk Management practices
  • VaR appears to be useless in estimating potential losses of highly negatively skewed portfolio.

Stress tests have been aptly proposed by the risk managers to overcome the VaR pitfalls. Hence Stress testing is used as a supplement to VaR by Risk managers.
From VaR to Stress Testing
Stress tests are all about examining how well a portfolio performs under some of the most extreme market moves seen in the last 10 to 20 years. It can take a large no of risk factors into consideration. Stress testing can be in the form of either sensitivity analysis or scenario analysis.

Commonly used events used in scenario analysis are the Asian Financial crisis of 1997, US Stock market decline of 1987 etc.
An analyst who employs stress testing as a technique to analyse future behaviour of a portfolio in response to certain stress events, tries to find answers to the following questions:
  • What happens if interest rates go up by 2%?
  • What happens if GDP falls by 3.2% in the current year?
  • What happens if taxes on POL (Petroleum, Oil & Lubricant) imports rise by 200%?
  • What happens if the US stock market crash by 50% this year?

The above type of analysis has become increasingly widespread and is increasing being taken up by various regulatory institutions to ensure organizations are adequately capitalized to absorb potential losses.


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