Value at Risk

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What is Value at Risk? Meaning.

Value at Risk models (VaR) are widely used for by banks and other financial institutions for risk management, risk reporting, risk limits, regulatory capital, internal capital allocation and performance measurement. Complex computer algorithms are being used to calculate the maximum that the institution could lose in a single day’s trading. These models seem to work well in normal conditions but not, alas, during financial crises, which is arguably when it is most necessary to know how much value is at RISK.

Some common VaR models are: 1) Variance-Covariance (VCV), assuming that risk factor returns are always (jointly) normally distributed and that the change in portfolio value is linearly dependent on all risk factor returns, 2) Historical Simulation, assuming that asset returns in the future will have the same distribution as they had in the past (historical market data), and 3) Monte Carlo simulation, where future asset returns are more or less randomly simulated.

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