Value-at-risk refers to the statistical measure of the riskiness of financial entities or the different portfolios of assets. This is taken to be as maximum dollar amount, expected to be lost over a given time horizon, at a confidence level that is defined well beforehand. Calculation of value-at-risk (VaR) can be done making use of various techniques such as parametric method, historical method and Monte Carlo method. The details of the method are as given in the section below. The calculation of VaR is done by carrying out proper assessment of the amount of potential loss, the frame of time in which it might take place and most importantly the probability of the loss. In general, the value of VaR is presented in form of percentage within a specified frame of time. One primary advantage of VaR is that it can be understood and used easily when doing any sort of analysis. It is again the reason why VaR is made use of by investors or firms to look at their potential losses. This as well is used by traders for the purpose of controlling their market exposure. VaR considers all of the odds associated with losing money and acts as a guide that can help to develop a risk management strategy. There are some cons of VaR as well such as one will not get any such standardized process for gathering the data required for determination of VaR. This means that various methods of VaR yield varied results and thus there are chances that actual risk to portfolio be much higher as compared to the VaR figure.
Calculation
Three different methods of carrying out calculations of VaR are the historical method, the Monte Carlo simulation and lastly the variance-covariance method. The first method that is the historical method just re-organizes the original historical returns, putting the same in order from worst to best. There is an assumption made here that history in some way will repeat itself, from the point of view of risk. On contrary to this, variance-covariance method takes the assumption that stock returns are normally distributed. In simple words, here it is required that estimation be done on two factors that are expected return and standard deviation. With this one can easily draw a normal distribution curve. Monte Carlo Simulation is the most popular method of the present times and in this there is a process undertaken to develop a model for future stock price returns and to run multiple hypothetical trials by means of the model. Using this, trials get randomly generated and one does not get to know about the underlying methodology. For most of the users, Monte Carlo simulation is “black box” generator of random and probabilistic outcomes.
Using all these methods of VaR one gets to calculate the maximum loss that is expected on any investment, across a time period and provide specific degree of confidence. There are three different in general methods that are commonly used to calculate VaR and have their own advantages and disadvantages. Click here toknow more about - Day Trading
Some examples at VaR are as given below:
VaR= [Expected Weighted Return of the Portfolio− (zscore of the confidence interval× standard deviation of the portfolio)]× portfolio value
Standard deviation of portfolio refers to the standard deviation of the rate of return on an investment portfolio. This is made use of to take a measure of the inherent volatility of any specific investment. It is best applicable for measuring risk towards investment and is of much help as well to analyze the stability of returns of the portfolio.
Certain steps need to be followed to calculate VaR in Excel:
In the domain of finance, Z-scores refer to the measure of variability of an observation that is made use mainly by traders to determine volatility of the market. This is also termed as Altman Z-score and in simple terms is a statistical measurement of a specific score’s relationship to the mean in a group of scores.
VAR= [Rp – (z) (σ)] Vp
Rp = Return of the portfolio.
Z= Z value for 5% level of confidence in one tailed test.
σ = Standard Deviation of the portfolio.
Vp= Value of the portfolio
Advantages of VaR are many as already mentioned above but its use in risk budgeting process increases its significance manifold.
Conclusion
Thus, VaR certainly is a significant risk measure that is made use of by the portfolio managers around the globe. The ease with which this can be understood is the reason for wide acceptance by regulatory bodies. The advantages that it is laced up with is also beneficial for the fund management companies. It needs to be understood that though the advantages outweigh the disadvantages of VaR, there is a need to take a note of limitations at the time when it is being used. Doing so will help ensure that nothing goes wrong and expected outcome is obtained. Click here toknow more about - Spread Trade
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