Value at Risk

 The rapid growth of derivatives in recent years—growth both in the amounts traded and in the innovative new products developed—has introduced major new complexities into the problem of measuring market risk. Banks and other institutions have seen the need for new and more sophisticated techniques adapted to the changed market situation. Consider, for example, the question of the valuation of derivatives. If a trader entered into a contract for the forward purchase of $10 million of pounds sterling six months hence at today’s 6-month forward price for GBP, the notional or face value of the contract would be $10 million. The market value (gross replacement value) of the contract would at the outset be zero—but that market value could change very abruptly and by significant amounts. Neither the notional value of that forward contract nor the snapshot of the market value as of a particular moment provides a very precise and comprehensive reflection of the risk, or potential loss, to the trader’s book. For currency options, the problem is much more complex—the value of an option is determined by a number of different elements of market risk, and values can change quickly, moving in a non-linear fashion. Market participants need a more dynamic way of assessing market risk as it evolves over time, rather than measuring risk on the basis of a snapshot as of one particular moment, or by looking at the notional amounts of funds involved. In a report of the Group of Thirty entitled Derivatives: Practices and Principles, industry members recommended a series of actions to assist in the measurement of market risk. They recommended that institutions adopt a “value at risk” (VAR) measure of market risk, a technique that can be applied to foreign exchange and to other products. It is used to assess not only the market risk of the foreign exchange position of the trading room, but also the broader market risk inherent in the foreign exchange position resulting from the totality of the bank or firm’s activities. VAR estimates the potential loss from market risk across an entire portfolio, using probability concepts. It seeks to identify the fundamental risks that the portfolio contains, so that the portfolio can be decomposed into underlying risk factors that can be quantified and managed. Employing standard statistical techniques widely used in other fields, and based in part on past experience, VAR can be used to estimate the daily statistical variance, or standard deviation, or volatility, of the entire portfolio. On the basis of that estimate of variance, it is possible to estimate the expected loss from adverse price movements with a specified probability over a particular period of time (usually a day).

Value at Risk