“How much do you stand to lose, over a certain period and with a certain probability? What is that number and what does it stand for?” The number being referred to here is Value at Risk or VaR for short. A worst case loss with limits on time period and probability. VaR uses historical market trends, volatility and correlation to estimate the likelihood that a given portfolio’s losses will exceed a certain amount.
VaR comes in many flavors. Value at Risk, Conditional Value at Risk, Incremental Value at Risk and Marginal Value at Risk. Its usage in capital allocation and risk budgeting took off after formal adoption by the BIS Committee & the Basel II accord.
VaR has taken enormous flack, especially after the 2007-2008 financial crisis. Like any other statistical tool, VaR is not perfect and the context around its usage and application determine its value. However as a risk manager, trader or regulator it is important to familiarize one with the concepts behind Value at Risk Calculations.
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