Value at Risk (VaR) a statistical tool to measure and quantify financial risk within a firm or portfolio over a specific time frame. This metric is often used by Banks to determine the extent and probability of occurrence of a potential loss on the advances. It is also widely used by risk managers to measure and control the level of risk exposure. It can be applied to a specific position or the whole portfolio. It is quite commonly used as a tool for Risk Management.
VaR modeling is used to determine:
For example, a financial firm may use VaR and determines that one of its assets has a 6% one-month VaR of 1%, representing a 6% chance of the asset declining in value by 1% during the one-month time frame. The conversion of the 6% chance of occurrence to a daily ratio places the odds of a 1% loss at one day per month.
The formula to calculate Historic VaR is-
[Expected weighted return of the portfolio − (z-score of the confidence interval × standard deviation of the portfolio)] × portfolio value
Z score = (return of an instrument - mean return) / Standard deviation
Investment banks, Hedge funds, and other AMCs commonly apply this technique of VaR modeling to assess the firm-wide risk due to the potential for independent trading desks to unintentionally expose the firm to highly correlated assets.
Using VaR assessment at such a firm-wide level allows them to determine the cumulative risks from aggregated positions held by different trading desks and departments within the investment bank. By using the data provided by such VaR modeling, Investment Banks can check, at any point, whether they have sufficient capital reserves in place to cover losses or whether higher-than-acceptable risks require them to reduce concentrated holdings.
In short, be it an individual or a fund house, a retail banking institution, or an investment bank, VaR is a tool that equips them all to quantify the active risk exposures of their singular asset/positions or across a portfolio. It is also the most common tool after standard deviation for measurement and management of risk for investors worldwide.
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