Value At Risk (VaR) Explained

Value At Risk (VaR) is probably the most important metric, that’s used in the Financial Industry today, to manage risk. Everyone from Big Institutions to small Hedge Funds, use VaR to assess and manage risk on real-time basis. Despite this, you might have never heard of VaR, which is understandable, cause you aren’t suppose to. In this post, I will try my best to be as simple, and uncomplicated as I possibly can. Now keep in mind, you don’t need to obsess over how a VaR is calculated, or the different VaR models that exist. All you need to know is, WTF it is and how to use it.

Different institutions have their own unique (or not) methods/models of calculating VaR. It is recommend that, once you adopt a VaR model, you stick with it, and not constantly change it in order to cover-up your losses. That’s what happened with JPMorgan’s London Whale fiasco.

Explanation:

Think of VaR as a Limit/Threshold, that if breached, can lead to massive losses, depending on the size of your position.

Lets say Stock XYZ is trading at $100. You buy 1000 share of XYZ @ $100,000. One way to calculate the VaR of your position, is to look at and analyze the historical behavior of XYZ. In this case, lets say we look at the data for the past 3 months, and we analyze how the stock’s price has behaved over that period. Using statistical methods, you can get Mean and the Standard Deviation, and you can construct a normal distribution, and visually see which way the data is skewed. After this, you calculate the VaR using the statistical method of Confidence Intervals. Different institutions use different confidence intervals, depending on the risk they are willing to take. Lets say we use a 95% VaR in our calculation, and we arrive upon a number: $10,000. What this means is, there’s a 95% chance that you wont lose more than $10,000 on your position in XYZ stock (1000 shares).

Every time the losses exceed the Limit/Threshold of $10,000, institutions start shitting their pants; especially if the Security/Financial Instrument that they’re holding is Illiquid.

VaR can also be calculated using Monte Carlo Simulations (Method).

Hope this post helped you get a better, if not perfect, understanding of what Value At Risk (VaR) is and how it is used.

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  • Glyn A Holton

    Thanks for this nice explanation. While I am a proponent of VaR, I am not sure I agree it is the most important metric for managing risk today. Good old volatility remains an ubiquitous metric.