If you invest online or hold a stock portfolio, you have probably already heard of the term "value at risk". It was invented in the 80's by Bankers Trust for the US financial markets and democratized in the 90's by JP Morgan with its RiskMetrics system. Before this period, it was impossible to compare the different risk measures of market activities with the methods used. Over time, however, derivatives have multiplied and the volatility of financial markets has increased significantly, leading to successive stock market crashes. This led financial institutions to develop a common risk indicator model. This is how the indicator we will talk about in this article was born and has become, since the Basel agreements in 1995, one of the essential indicators for the evaluation of financial risk.
Let us first take a moment to define Value at Risk more precisely. This term refers to the maximum potential loss for an investor on a given asset or portfolio of assets that can be achieved with a specific probability and a given time horizon. It is therefore the worst possible scenario over a given period and associated with a confidence index.
The Value at Risk can thus be interpreted as an indicator of the distribution of profits and losses for an asset or group of assets for a specific period.
In defining this risk measure, three distinct elements are considered here with :
In order to evaluate the Value at Risk, it is also necessary to make three main assumptions. The first concerns the normality of the profit and loss distributions, incorporating the fact that the evolution of the price of a financial instrument is considered to follow a lognormal distribution. A second assumption concerns the relationship between an N-day Value at Risk and a 1-day Value at Risk, since it is considered here that the N-day VaR is equivalent to the square root of N multiplied by the 1-day VaR. The last assumption concerns the average return on a financial asset, which is considered to be zero for the period in question.
As mentioned above, the calculation of the VaR depends largely on the estimation of the loss distribution. There are two methods for doing this. The oldest method is to use only the value of the position in the past. In the case of a portfolio of assets, the past value of the portfolio will be reconstructed from the different prices of the assets in its current composition. Once the risk factors have been determined, the historical data will be used to deduce a loss amount. In this method, little calculation and technique is used. Furthermore, this method of assessing VaR does not require any prior assumptions about the shape of the distribution. However, the fact that this method is so simple also has some disadvantages. Indeed, it is necessary here that the history is sufficiently large compared to the horizon of the VAR and its confidence level, but that it is not too large either, in order to ensure that the probability distribution has not changed too much over this period. Another drawback of this method is that it does not work for derivatives.
However, there is another common method of calculating VaR, which is the analytical or parametric method. This is based on statistical calculations and consists of defining a formula representing the profits and losses. This second method is based on various assumptions, including the fact that variations in risk factors follow a normal distribution, that the relationship between variations in portfolio values and variations in market values is linear, and that derivatives are linear and bonds can be reduced to linear payoffs.
Let's now look at the concrete use of the Value at Risk indicator and the people or institutions for whom it is intended. In reality, VAR is mainly used by banks and is intended for market professionals such as market operators, private fund managers or institutional fund managers, risk managers who are responsible for risk management and risk control, as well as accountants and institutional clients.
As we have just seen in this article, the Value at Risk represents the maximum potential loss of an asset over a given period. But we have also seen that its evaluation is often based on imprecise elements that can have a direct influence on the result obtained.
The limitations of the Value at Risk mentioned above have led to the introduction of additional control methods such as backtesting and stress testing, which are now mandatory in order to verify the results of this indicator. Backtesting is used to determine the number of times the actual loss exceeded the VaR estimate. If this number is large, it is necessary to review the calculation method used. Stress testing is another method of validating VaR introduced by the Basel Committee. These mandatory tests work by subjecting asset portfolios to extreme market conditions in order to observe their behaviour in the face of extremely negative scenarios.
However, although Value at Risk has some shortcomings that we have just explained to you, it remains an interesting evaluation tool for risk management by providing a quantitative measure of this risk. You should therefore take this indicator into account when speculating on an asset or a portfolio of assets, but you should also use other risk assessment methods in parallel and place your stop orders at the right levels.
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