Value at risk is a method that is used to determine the possible risk of loss for a particular type of investment. This is a strategy that attempts to determine what the worst-case scenario is for a particular investment or a portfolio. Institutional investors often use this method. This statistical measure essentially looks at the level of volatility of an investment.
However, instead of just looking at volatility, it takes the analysis even further. Most investors do not necessarily care if an investment is volatile, as long as it is increasing in value. If it increases in value rapidly, this would be volatile.The investor only cares if the investment loses a large amount of money, in a specific amount time. Value at risk looks to determine what the worst possible loss is for an investment over a specific time period.
This technique is a vital component of risk management. When an institutional investor, or an individual investor, looks at the value at risk of investment, it forces them to deal with the risks and hand. Many investors get in the habit of forgetting about risk and only review possible returns. With this strategy, they are more likely to gauge the actual risk of their investments and invest safely.
Value at risk is also commonly used in risk measurement techniques. Analysts will typically report the value at risk as part of other financial risk values, such as standard deviation and expected shortfall. By using value at risk, an investor can put a value on the possibility of losing money on an investment without making assumptions like they do with other valuation methods.
Types of Value at Risk
Value at risk can be calculated in a number of ways. One of the most popular methods of calculating value at risk is the historical method. With this method, a graph is created and the historical returns of a security are organized, from worst to best. By looking at this, you can see how frequently a return was generated with this investment. This method can tell you how confident you should be that a large loss will not occur on a given day.
Another method that is used is the variance method. This method is similar to the historical method except that it uses an expected return and a standard deviation on a curve.
The third method is a Monte Carlo simulation. This is a simulation that is conducted with a statistical model on a computer with random data being used.
Even though the value at risk information can be beneficial, it sometimes leads to a false sense of confidence. It is very difficult to predict when rare events will occur. Even if you can be 95 percent confident that today you will avoid a large loss, there is still a 5 percent chance that one could occur.