This blog is an extension of our blog on Financial Markets Products.
In this session, we will share with you Tips on ‘Value at Risk’
1. VaR represents maximum potential loss in value of a portfolio of financial instruments with a given probability over a certain time horizon.
2. VaR for a portfolio has similar concept as standard deviation for a portfolio has:
3. VaR can be measured with two methods: (i) Linear Valuation Method: a) Delta Normal Method (ii) Full Revaluation Method (a) Historical Simulation (b) Monte Carlo Simulation
4. Linear Valuation doesn’t work for portfolios of non-linear securities
5. There are two explanations for the Fat Tails: (i) Conditional Mean: Mean changing over the period of time (ii) Conditional Volatility: Volatility changing over the period of time
6. Implied Volatility: It is forward-looking, predictive. It is the value for σ such that Black & Scholes price is equal to the observed market price
7. Full Revaluation Method accounts for non-linearity of derivatives whereas delta normal assumes a linear approximation. It is also important to understand that it accounts for extreme fluctuations
8. You can expect at least 1 question on Historical Simulation. It has a benefit that there are no assumptions required about the distribution of returns. It is not exposed to any model risk. The biggest drawback with the Historical Simulation method is that the changes in volatility and correlation from structural changes are not recognized
9. The Monte Carlo approach assumes that there is a known probability distribution for the
10. The best methods depend on speed required and whether the portfolio has non-linear elements
11. One shall understand that: Some companies define operational risk as all the risk that is not market or credit risk. But this is a very broad definition of operational risk. The Basel definition of operational risk is “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events
12. One should remember that there are two kinds of rating: (i) Internal Rating (ii) External Rating
13. Transfer risk is the risk that the government will impose restrictions on the transfer of funds by debtors in the country in question to foreign creditors, either for financial or other reasons. This risk is almost exclusively related to foreign currency exposure
14. It is important to understand Expected Loss: EL = Exposure * LGD*PD. EL is the amount the bank can lose on an average over a period of time
15. Banks need to create a loan loss reserve based on historical data for the losses which they expect. Expected Loss (EL) is based on certain values of UGD, LGD, PD which are calculated. The Banks need to be prepared with some capital if the EL varies from the average historical behavior. This deviation from the average EL is known as Unexpected Loss (UL)
16. The required capital reserve – which acts as a buffer against insolvency for the bank in the event of the default by an obligor – is known as economic capital.
We hope that this tutorial must have given you good insights into ‘Value at Risk (VaR)’.