An Introduction to Value-At-Risk, Fourth Edition

Chapter 3

VALUE-AT-RISK

The advent of value-at-risk (VaR) as an accepted methodology for quantifying market risk and its adoption by bank regulators are milestones in the evolution of risk management. The application of VaR has been extended from its initial use in securities houses to commercial banks and corporates, following its introduction in October 1994 when JP Morgan launched RiskMetrics free over the Internet.

In this chapter we look at the different methodologies employed to calculate VaR, and also illustrate its application to simple portfolios. We look first at the variance–covariance method, which is arguably the most popular estimation technique.

WHAT IS VaR?

VaR is an estimate of an amount of money. It is based on probabilities, so cannot be relied on with certainty, but is rather a level of confidence which is selected by the user in advance. VaR measures the volatility of a company's assets, and so the greater the volatility, the higher the probability of loss.

Definition

Essentially VaR is a measure of the volatility of a bank trading book. It is the characteristics of volatility that traders, risk managers and others wish to become acquainted with when assessing a bank's risk exposure. The mathematics behind measuring and estimating volatility is a complex business, and we do not go into it here. However, by making use of a volatility estimate, a trader or senior ...