A quick guide to value at risk, (VAR)
This is a simple explanation of VAR. It explains what it is, how it can be used and
some of the strengths and weaknesses it has.
Market Risk
Traders buy and sell financial products. As a result they often have
positions or exposures. These exposures can arise because they are
speculating or they have taken the other side of a client trade.
Whatever the reason as prices move the market value of these
positions will change.
This means that movements in foreign exchange rates, interest
rates, credit spreads and commodity prices lead to profits and
losses. This is called market risk. One of the most popular methods
of measuring market risk is value at risk, (VAR). It has been used
by banks for over a decade.
What does it show?
VAR tells you how much money you can lose over a given time
period and for a given level of confidence from the positions you
hold. But it is not a guaranteed maximum loss figure. Your
positions could lose you a lot more than VAR indicates.
Sometimes markets move by huge amounts in very short space of
time. As a consequence your dealing positions can give you losses
much greater than the VAR you have calculated.
It is this point that senior managers should be aware of. VAR is not
a guaranteed maximum loss figure. Giving your dealers a VAR limit
will not mean they cannot lose more.
What affects VAR?
Four main factors influence your VAR number, they are:
1. Exposure: In general the larger the position you have the
greater the risk. Therefore large positions create greater
VAR.
2. Time: The longer you intend to hold the position the
greater the VAR. As you may expect 10 day VAR is
greater than 1 day VAR. (But not by a factor of 10, only
the square root of 10).
3. Confidence: If you want a VAR that is very unlikely to be
exceeded you will need to apply more stringent
parameters. All things remaining constant this will
increase your VAR and make it less likely to be exceeded.
4. Volatility: If you deal in risky things that have a history of
going up and down in price, or if market conditions alter
to make your positions move up and down in price your
VAR will tend to increase.
It is important to put any VAR number you see into context. This
means that if you are provided with a VAR number you should also
know:
1. What is the probability that it will be exceeded?
2. What is the holding period?
Without this information you will be unaware of the parameters
that have been used in the calculation of the VAR that you are
working with.
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What are the advantages?
VAR has several advantages, they are:
VAR is just one number and in that sense becomes a lot
easier to understand and monitor.
VAR provides you with a statistical measure of the
probability of loss. Risk measures like duration and basis
point value, (DV01), do not provide a statistical measure
of the likelihood of loss. They just give you an absolute
risk figure rather than a probability of such a loss arising.
Therefore VAR is an improvement on these techniques.
VAR can be calculated for all types of assets. This means
you can calculate VAR for interest rate risk, foreign
exchange risk, credit risk and commodity price risk.
Some firms add these individual VARs together to arrive
at an overall VAR. You cannot do this with other risk
measures.
What are the disadvantages?
There are some weaknesses you should know about, they are:
VAR is not a maximum loss figure. From time-to-time
you may find that the actual amount of money lost
exceeds the VAR.
If you experience a loss greater than your VAR there is
no guarantee that you will not experience another loss
that exceeds your VAR the following day as well.
Many IT systems find the calculation of VAR challenging.
Sometimes banks rely on spreadsheets to do this.
Calculation errors and stale data can lead to inaccurate
VAR reports.
Inaccuracy and doubts in the validity of VAR can also lead
to it being used as a soft limit. The breaking of a risk
limit based on VAR is then treated with less seriousness
than would otherwise have been the case.
Banks using VAR for the first time may be tempted to set
a VAR limit much higher than the risk they have. The
limit is so far from being breached that no one pays
attention to VAR as a risk measure.
VAR does not deal with option positions very well. It also
does not measure operational risks. This means that you
can have losses that arise from poor controls and fraud.
Is there anything we can do to improve the
situation?
Yes. Many firms do not solely rely on VAR to manage market risk.
They use a variety of measures that may include traditional
techniques like basis point value and stress testing. Stress testing
shows what can happen when extreme market moves arise. It
focuses attention to what can happen when markets move
abnormally. You can see what a bad day could really cost you. By
using several measures banks are looking for consistency in the
reporting of risk. It is like having a second, third and fourth check
on VAR.
 VAR and diversification
In financial markets diversified asset portfolios are generally
considered to be less risky than undiversified portfolios. If you have
three traders one trading foreign exchange, another interest rates
and the third credit, on most days you should get some
diversification benefits. When one trader has a bad day another one
will have a good day. The volatility of your profit and loss should be
reduced.
When risk managers calculate VAR they can take into account this
diversification effect. They can provide you with both undiversified
and diversified value at risk.
The undiversified VAR figure tells you what might happen on a bad
day. Undiversified VAR is a summation of the individual product
VARs. This is when your foreign exchange trader, interest rate
trader and credit trader all lose money together.
Diversified VAR takes into account the portfolio effect. This is
important. It means in theory that adding trades or products can
lead to changes in the VAR that are not as great as you may
anticipate. (A theory that is anecdotally supported by some
managers who use VAR).
Many banks therefore use the diversified VAR as an indication of
what can happen in normal market conditions.
VAR & regulators
Regulators will not tell you how to calculate your VAR. But they are
known to probe the methodology that is being used, question how
appropriate it is and also assess senior managers understanding of
the risk measures the firm is using.
In general regulators are supportive of firms using VAR. Many firms
have agreed with the regulator the use of VAR in order to calculate
market risk and therefore the amount of regulatory capital required
to support it.
If you agree to use VAR then the VAR model needs to be an
accurate assessment of the risks you run. Therefore if you expect
your VAR to be exceeded only 1 day in 100 days your regulator will
not appreciate a frequency that exceeds this. It would indicate that
your VAR model is inaccurate and your regulator may decide to
increase the amount of regulatory capital you are holding.
If you pick a more risky security, say one with a daily volatility of
1% your one day VAR for a 99.8% confidence interval is 3%,
$300,000 on a $10m position. Increased volatility increases VAR.
This also means that if volatility changes your VAR can increase or
decrease even when you positions remain unchanged.
What confidence interval and holding period should be used? That
is entirely up to you. In determining the time horizon you may wish
to consider how long it could take to liquidate positions. Many
banks use between 5 and 10 days with a 2 or 3 standard deviation
confidence interval. It just depends on how conservative you want
your risk measure to be. ***
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*VAR uses standard deviation; this is sometimes referred to by
traders as volatility. A standard statistical text book will explain
standard deviation; it can also be calculated using spreadsheet add-
in functions. It is a measure of the historic or implied price
fluctuation of dealing positions and requires observing and
collecting daily asset prices. Put simply the more an asset goes up
and down in price the more volatile it is and the greater the
perceived market risk. High price volatility equals high risk.
**Because financial markets do not strictly conform to normal or
lognormal distribution the probability of a loss exceeding the VAR is
greater than would be indicated. In real life the tail under the
distribution curve is fatter than expected.
***As a rule of thumb, VAR increases with the square root of time.
So if you want to calculate the VAR with a 99.8% confidence
interval for a 10 day holding period for the asset with a 0.5% daily
volatility the 10 day VAR will be 3.16 (square root 10) x 1.5 =
4.74% or $474,000 for a $10,000,000 position.

Finally a few numbers

By way of illustration the following provides a simplified VAR
calculation. Suppose you own a bond that has a price of 100% and
you have calculated that the daily price volatility is 0.5%*.

Using statistics, (standard deviation, SD), there is an 84.1%, (1

SD), chance, that the price tomorrow will not fall below 100%-
0.5%= 99.50%, a 97.7%, (2 SD), chance that the price tomorrow William Webster
will not fall below 100%-1%= 99.00% and a 99.8%, (3 SD), Barbican Consulting Limited
chance that the price tomorrow will not fall below 100%-1.5%= Financial Markets Training
98.50%.
wwebster@barbicanconsulting.co.uk
Put another way you are 99.8% certain that in normal market 00 44 (0)20 79209128
conditions your loss on holding this asset for one day will not
exceed 1.5%, ($150,000 on a $10m position), this is the VAR**.

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