What is Value at Risk?

by Investing School on April 13, 2011

The term “Value at Risk” (VaR) is commonly used in both financial mathematics and financial risk management. It is a calculation and measurement of the possible risk of a loss for a certain portfolio of combined financial assets. Value at Risk determinations are defined for a portfolio within a specific probability and time horizon, and offered as a threshold value. This means that the probability that the loss on the portfolio in question, during a particular time horizon, exceeds this value as the probability level. This assumes normal markets, as well as no trading within the portfolio.

As an example, consider a situation in which a hypothetical portfolio of securities has a one-day 5% Value at Risk of $2 million. In this case, that means that there is a 0.05 probability that this portfolio in question would decrease in value by an amount in excess of $2 million during one day period. Again, that is assuming that the markets are normal and there is no trading within the portfolio.

The VaR in the above scenario could also be described this way – a decrease of $2 million or more within this portfolio could possibly be anticipated for one day out of twenty. If there is a situation in which there is a loss that is more than the VaR threshold, this loss is known as a “VaR break.”

The VaR is used for five purposes in financial world: risk measurement, risk management, financial reporting, financial control and computing regulatory capital.

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