Pros and cons of value at risk (VaR)
Pros of value at risk
One of the main advantages of the VaR metric is that it is easy to understand and use in analysis. This is why it is often used by investors or firms to look at their potential losses.
The metric can also be used by traders to control their market exposure. Normally, a traditional measure of risk is market volatility, but this might not be useful for traders as volatility can create a range of opportunities to go long and short. Instead, VaR looks at the odds of losing money and can act as a guide to creating a risk management strategy.
Cons of value at risk
There isn’t a standardised process for gathering the data needed to determine the VaR, which means that different value at risk methods can lead to different results.
It is important to understand that VaR by no means shows a trader the maximum possible loss; it is simply the probability that a loss will occur. The actual risk to a portfolio could be higher than the VaR figure, which is why value at risk should be used as just one small part of a risk management strategy.