Financial Risk Management For Dummies

Chapter 6

Valuing Risk

In This Chapter

Defining, estimating and testing Value at Risk (VaR)

Using VaR in risk decisions

Understanding variations of VaR

Value at risk (VaR), the amount of money a fixed portfolio will lose over a fixed time horizon with a fixed probability, is the oldest and best-known concept developed in the field of financial risk management. This concept is an essential tool for managing financial risk. However, although practising financial risk managers are unanimous in their reliance on this tool, VaR is highly controversial outside the profession. So while you use VaR to manage risk and to communicate with risk professionals, be wary of using it outside the profession.

A VaR break is when the fixed portfolio loses more than the VaR amount over the fixed time horizon. It’s not a bad thing; if you never have any VaR breaks, then you’ve set your VaR too high. If you estimate a 95 per cent one-day VaR, for example, you expect 5 per cent of days – that is one day out of 20 – to be a VaR break. If you have much more or much less than 5 per cent breaks, you need to fix the way you estimate your VaR.

In this chapter, I begin by describing the simple, pure VaR from ...