Value at risk (VaR) definition

Value at risk (VaR) example

The value at risk to a position is calculated by assessing the amount of potential loss, the probability of the loss and the time frame during which it might occur.

This is normally then presented as a percentage within a given timeframe. For example, it could be said that an asset has a 2% one-week VaR of 1%. This means that there is a 2% chance that the asset will decline by 1% within a single week.

However, it could also be presented as a numerical value. For example, if a portfolio has a 5% one-day VaR of $1000, it means there is a 5% chance that the portfolio will decline by $1000 during a day.

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.