Value at Risk VaR – Measures Market Risk in Trading Transactions
Market risk in trading transactions or trading book is the risk taken through holding mismatched positions in financial instruments (interest rates, foreign exchange, equity or commodity) either on balance sheet or off balance sheet. Market risk is measured using the “Value at Risk” concept (“VaR”).
“Simple” VaR Definition
- Assuming the future is like the past, VaR is the estimation of a maximum loss within a given confidence level.
- Therefore, if the confidence level is 99%, and VaR is USD50m, you should not expect to loss more than USD50m in 99 out of 100 days.
- VaR is a model based on historically observed market factors.
What VaR is:
- A calculation of maximum likely loss in a given period of time in the event of extreme market moves.
- Calculated at a particular confidence level (best practice: 99%)
- Calculated over a selected time period (best practice: 10 days)
- Based on historical price movements (typically, between 100 business days and 250 business days).
- Demanding of systems resources
What VaR is not:
- A method of avoiding trading losses (small repeated losses)
- Infallible (historical distributions may not continue)
Limitations to VaR
- Based on historical statistics: Past not always good indicator of the future
- May not cover unusual market conditions, such as LTCM (Long-Term Capital Management)
- Time horizon may be inappropriate (liquidity)
- Not appropriate for inactively traded products, such as asset backed securities (ABS)
- Some market risks are “difficult” to model correctly.