Mastering Illiquidity: Risk management for portfolios of limited partnership funds

9

Value-at-Risk

The VaR concept has become a standard approach in the toolkit of financial risk managers and regulators. Generally, the VaR is interpreted as the maximum mark-to-market loss a given portfolio can suffer for a given time horizon and a given confidence level. In essence, the VaR aims to calculate the portfolio impact of rare events. For instance, on a 1-year horizon and at a typical confidence level of 99.5%, the estimated loss should occur only once every 200 years, given historical market movements of asset prices (for a general overview of the VaR concept, see Jorion, 2006).

The VaR has been criticized for a number of reasons. For instance, it has been claimed that the VaR gives a false sense of confidence as it ignores tail risk and may even lead to excessive risk taking. Rather than making VaR control the chief concern, it has been claimed that it is far more important for risk managers to worry about portfolio losses that may be suffered if the VaR is exceeded. While we agree with most of the criticism, we believe that the VaR may still provide important insights for a risk manager as long as he is aware of the shortcomings of the approach. We concur with Jorion and Taleb (1997), who argue that “the greatest benefit of VAR [sic] lies in the imposition of a structured methodology for critically thinking about risk. Thus the process of getting to VAR [sic] may be as important as the number itself”.

While we have little to add to this debate, we start from the ...