Value at Risk

An overview

Value at Risk
The Need for VaR
Definition of VaR
Uses of VaR
VaR Methods
VaR - Historical Simulation
Changes since the Financial Crises of 2008
Strengths and Weakness
Summary

Options, Futures, and Other Derivatives 6th Edition, Copyright John C. Hull 2005
18.2

Value at Risk
The Need for VaR
Different Asset Classes use their own measures
Fixed Income Duration
Interest Rates DV01
FX Currency position
Commodity Number of contracts
Equities Number of shares
Using these to compare risk in these portfolios is like comparing
apples and oranges.

An investor or owner needs a simple measure that can be used in

a consistent way to compare risk between these portfolios.
And with the ability to aggregate risk appropriately
Value at Risk is that risk measure

Definition of VaR
VAR is a measure of losses due to normal market movements
Value at Risk (VAR) calculates the maximum loss expected (or
worst case scenario) on an investment, over a given time period and
given a specified degree of confidence.
VAR is the answer to the question How much could we lose over a
specified holding period with a defined probability
.There are three key elements of VAR
- a specified level of loss in value,
- a fixed time period over which risk is assessed
- a confidence level.

Options, Futures, and Other Derivatives 6th Edition, Copyright John C. Hull 2005
18.4

So if a portfolio has a VaR of $20 million

We need to know the confidence level used to calculate
We need to know the holding period (time horizon)
For example there is only a 5% chance that our company's
losses will exceed $20M over the next five days;. This is
the classic VaR measure. VaR does not provide any
information about how bad the losses might be if the
VaR level is exceeded. 09/26/10 Last Updated:
September 26, 2010

Options, Futures, and Other Derivatives 6th Edition, Copyright John C. Hull 2005
18.5

Suppose that it is determined that a $100 million portfolio

could potentially lose $20 million (or more) once every
20 trading days.
The VaR of this portfolio equals $20 million with a 95%
level of confidence over the coming trading day; 19 out
of 20 trading days (95% of the time), losses are less than
$20 million
At the 95% confidence level, VaR represents he border
of the 5% left tail of the normal distribution, also known
as the fifth percentile or .05 quantile of the normal
distribution

Options, Futures, and Other Derivatives 6th Edition, Copyright John C. Hull 2005
18.6

Options, Futures, and Other Derivatives 6th Edition, Copyright John C. Hull 2005
18.7

This diagram shows that:

95% of the time, the portfolios value
remains above $80 million
5% of the time, the portfolios value falls to
$80 million or less
The VaR of this portfolio is therefore $100
million - $80 million = $20 million
Options, Futures, and Other Derivatives 6th Edition, Copyright John C. Hull 2005
18.8

FORMALIZATION AND
APPLICATIONS
VaR

can simply be expressed as

Options, Futures, and Other Derivatives 6th Edition, Copyright John C. Hull 2005
18.9