Pros and Cons of Value at Risk

When you think value at risk, you should think risk management, because value at risk (VaR) is essentially a mathematical formula used in risk management plans. Because of the great emphasis on risk management amongst professional investors and investing groups, there comes a need to quantify the risk in a portfolio. In essence, value-at-risk calculations derive the outstanding value that is at risk according to the degree of exposure the entire portfolio is carrying.

For example, take a pension portfolio with assets of $15 billion. Imagine that the entire portfolio is in cash reserves except for 10 percent that is invested in aggressive futures. That means 10 percent of the portfolio is entirely at risk. Therefore, the value at risk is .10*$15billion, which equals $150 million. Because our example was simple, we could use basic arithmetic. However, the value-at-risk tools used are highly complex.

This risk management model is one of the statistical probability theories that has been known to be shoddy when applied to the financial markets. Yet of course, the model would not be used at all if it didn’t confer benefits to those major financial banks and institutions that use it--and have the expertise to do so.

The Cons of VaR

Value-at-risk models cannot precisely model the true value that is at risk during times of market collapse, chaos and severe duress. Lots of money, time and effort is put towards these mathematically flawed risk management models when basic common sense and experience are known to achieve better results than these complicated systems.

The Pros of VaR

Nevertheless, one of the major benefits to this model is that it’s able to quantify to a degree of probability or percentage the dollar amount at risk in a certain portfolio. This affords top-level management a bird’s eye view of one of a series of metrics in order to validly interpret the balance, risk and overall efficiency of a portfolio. It’s up to management and experienced professionals to make informed decisions about the overall trend in the markets and what can be expected given certain scenarios. The value-at-risk metric is just one more valuable metric for their analytical database and should not be viewed as the be all and end all for bulletproof risk management.

VaR is pervasive, used by all the trusted banks. Because of the controversy surrounding the financial debacle in 2008, this risk management model has been under a great deal of scrutiny. It is known to be flawed; the statistical kurtosis of the financial markets is much higher than that of a normally distributed series. Proponents of the model know to adjust it in order to better model the markets realistically. However, if these models are more frequently being adjusted to fit the data, there must be a fundamental flaw within the theory of the model itself. Yet, there is not much of a replacement for value at risk. Those who know best know to use the model cautiously.

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