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Value at Risk Presentation
Value at Risk Presentation
Value at Risk Presentation
VAR
Content
What is VAR?
VAR questions
Historical Method
Limitations
Criticisms
VAR
• What is the most I can - with a 95% or 99% level of confidence - expect
to lose in dollars over the next month?
• It then assumes that history will repeat itself, from a risk perspective.
Historical Method
• TheWith 95% confidence, we expect that our worst daily loss will not
exceed 4%.
• If we invest $100, we are 95% confident that our worst daily loss will not
exceed $4 ($100 x -4%)
Historical Method
Weaknesses
• While all three approaches to estimating VaR use historical data, historical
simulations are much more reliant on them than the other two approaches
for the simple reason that the Value at Risk is computed entirely from
historical price changes.
A related argument can be made about the way in which we compute Value
at Risk, using historical data, where all data points are weighted equally. In
other words, the price changes from trading days in 1992 affect the VaR in
exactly the same proportion as price changes from trading days in 1998. To
the extent that there is a trend of increasing volatility even within the
historical time period, we will understate the Value at Risk.
The historical simulation approach has the most difficulty dealing with new
risks and assets for an obvious reason: there is no historic data available to
compute the Value at Risk.
Variance - Covariance
Method
• This method assumes that stock returns are normally distributed.
• The blue curve above is based on the actual daily standard deviation of
the QQQ, which is 2.64%.
Variance - Covariance
Method
Variance - Covariance
Method
Weaknesses
If there are far more outliers in the actual return distribution than would be
expected given the normality assumption, the actual Value at Risk will be much
higher than the computed Value at Risk.
To the extent that these numbers are estimated using historical data, there is a
standard error associated with each of the estimates. In other words, the
variance-covariance matrix that is input to the VaR measure is a collection of
estimates, some of which have very large error terms.
A related problem occurs when the variances and covariances across assets
change over time. This nonstationarity in values is not uncommon because the
fundamentals driving these numbers do change over time.
Monte Carlo
Stimulation
• The third method involves developing a model for future stock price
returns and running multiple hypothetical trials through the model.
• 100 hypothetical trials of monthly returns for the QQQ. Among them,
two outcomes were between -15% and -20%; and three were between
-20% and 25%.
• That means the worst five outcomes (that is, the worst 5%) were less than
-15%.
Monte Carlo
Stimulation
Limitations