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Value At Risk

Value At Risk. Traditional Method. The most popular and traditional measure of risk is  volatility .

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Value At Risk

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  1. Value At Risk

  2. Traditional Method • The most popular and traditional measure of risk is volatility. • The main problem with volatility, however, is that it does not care about the direction of an investment's movement: a stock can be volatile because it suddenly jumps higher. Of course, investors are not distressed by gains! • For investors, risk is about the odds of losing money, and VAR is based on that common-sense fact. • Question: “How bad can things get?”

  3. Var Method Value at risk (VAR or sometimes VaR) has been called the "new science of risk management” • VAR answers: a) What is the most I can - with a 95% or 99% level of confidence - expect to lose in dollars over the next month? b) What is the maximum percentage I can - with 95% or 99% confidence - expect to lose over the next year?

  4. Three Methods • Historical Simulation Method • Variance Co-variance Method • MonteCarlo Simulation

  5. Historical Simulation Method • The historical method simply re-organizes actual historical returns, putting them in order from worst to best • It then assumes that history will repeat itself, from a risk perspective • It looks at left tail 5% for possible risk

  6. Historical Simulation The right tail shows that worst 5% return are -4 to -8%. So there is chance of losing at this rate

  7. Variance Co-variance Matrix • This method assumes that stock returns are normally distributed. • it requires that we estimate only two factors - an expected (or average) return and a standard deviation - which allow us to plot a normal distribution curve • And risk is

  8. Variance Co-Variance Matrix • If STD of a stock AAA is 2.64%. . Then according to VCV the risk is

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