What is Value at Risk?
In its most general form, the Value at Risk measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. Thus, if the Value at risk on an asset is $ 50 million at a one-week, 95% confidence level, there is a only a 5% chance that the value of the asset will drop more than $ 50 million over any given week. In its adapted form, the measure is sometimes defined more narrowly as the possible loss in value from “normal market risk” as opposed to all risk, requiring that we draw distinctions between normal and abnormal risk as well as between market and nonmarket risk.
While Value at Risk can be used by any entity to measure its risk exposure, it is used most often by commercial and investment banks to capture the potential loss in value of their traded portfolios from adverse market movements over a specified period; this can then be compared to their available capital and cash reserves to ensure that the losses can be covered without putting the firms at risk.
Taking a closer look at Value at Risk:
1. To estimate the probability of the loss, with a confidence interval, we need to define the probability distributions of individual risks, the correlation across these risks and the effect of such risks on value. In fact, simulations are widely used to measure the Value at risk for asset portfolio.
2. The focus in Value at risk is clearly on downside risk and potential losses. Its use in banks reflects their fear of a liquidity crisis, where a low-probability catastrophic occurrence creates a loss that wipes out the capital and creates a client exodus. The demise of Long Term Capital Management, the investment fund with top pedigree Wall Street traders and Nobel Prize winners, was a trigger in the widespread acceptance of Value at risk.
3. There are three key elements of Value at risk – a specified level of loss in value, a fixed time period over which risk is assessed and a confidence interval. The Value at risk can be specified for an individual asset, a portfolio of assets or for an entire firm.
4. While the Value at risk at investment banks is specified in terms of market risks – interest rate changes, equity market volatility and economic growth – there is no reason why the risks cannot be defined more broadly or narrowly in specific contexts. Thus, we could compute the Value at risk for a large investment project for a firm in terms of competitive and firm-specific risks and the Value at risk for a gold mining company in terms of gold price risk.