Value at Risk (VaR)
In the 1990s, the CEO of J.P. Morgan famously asked his team: "I want a single number, every day at 4:15 PM, that tells me how much I could lose if things go wrong." That number became Value at Risk (VaR).
What is VaR?
VaR answers the question: "What is the maximum loss I might expect over a given time period with a given confidence level?"
It has three components:
- Amount: The maximum loss (e.g., ₹1 Lakh).
- Time Period: The horizon (e.g., 1 Day, 10 Days).
- Confidence Level: The probability (e.g., 95% or 99%).
Note
Example Statement: "The 1-Day 95% VaR of this portfolio is ₹10 Lakhs." Meaning: There is a 95% chance that you will NOT lose more than ₹10 Lakhs tomorrow. Or, there is a 5% chance that you WILL lose more than ₹10 Lakhs.
Why is VaR Important?
- Regulatory Requirement: Basel III norms require all banks to calculate VaR to determine how much capital they must hold in reserve.
- Risk Limits: Traders are given VaR limits (e.g., "You cannot take positions that exceed a ₹5 Crore VaR").
- Comparison: A way to compare the risk of a bond desk vs. an equity desk using a single currency number.
Limitations
- Not Worst Case: VaR does NOT tell you what happens in that worst 5% case. It just says "It will be worse than ₹10 Lakhs" but doesn't say if it will be ₹11 Lakhs or ₹100 Crores. (See Expected Shortfall).
- Model Risk: It assumes history repeats itself.
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