Value at Risk
Chapters 7 and 8 describe how a trader responsible for a financial institution’s exposure to a particular market variable (e.g., an equity index, an interest rate, or a commodity price) quantifies and manages risks by calculating measures such as delta, gamma, and vega. Often a financial institution’s portfolio depends on hundreds, or even thousands, of market variables. A huge number of these types of risk measures are therefore produced each day. While very useful to traders, the risk measures do not provide senior management and the individuals that regulate financial institutions with a measure of the total risk to which a financial institution is exposed.
Value at risk (VaR) is an attempt to provide a single number that summarizes the total risk in a portfolio. It was pioneered by JPMorgan (see Business Snapshot 9.1.) and has become widely used by corporate treasurers and fund managers as well as by financial institutions. As we shall see in Chapter 12, it is the measure regulators have chosen to use for many of the calculations they carry out concerned with the setting of capital requirements for market risk, credit risk, and operational risk.
Historical Perspectives on VaR