What Is Value-at-Risk?

Value-at-risk (VaR) is a risk measure that helps finance professionals estimate the maximum potential loss a portfolio might face over a given time frame, considering a set confidence level. For instance, a one-day 99% VaR of $10 million suggests a 99% likelihood that the portfolio’s loss will not exceed $10 million over one day, highlighting a 1% chance of exceeding this threshold.

The Role of Value-at-Risk in Risk Management

VaR’s utility spans several dimensions of risk management, offering vital insights for:

• Determining risk limits and budgets: Assisting organizations in setting quantifiable risk thresholds
• Regulatory compliance: Facilitating the calculation of capital requirements under regulations such as Basel III and Solvency II
• Model validation: Empowering financial institutions to backtest and validate VaR models’ accuracy
• Advanced risk metrics: Aiding in the computation of conditional VaR, conducting stress tests, and performing sensitivity analysis

Value-at-Risk Calculation Techniques

The methodology for computing VaR varies based on asset classes and risk exposure types. Common techniques include:

• Monte Carlo simulation: A statistical method to simulate a range of possible outcomes for a portfolio
• Copula-based portfolio simulation: An advanced approach to model dependency structures between assets
• Financial derivatives valuation: Techniques to assess the value and risk of derivatives
• Econometric modeling: Interest rate models, GARCH (generalized autoregressive conditional heteroskedasticity) models for volatility forecasting, and others

For more information, see Statistics and Machine Learning Toolbox™, Financial Toolbox™, Financial Instruments Toolbox™, and Risk Management Toolbox™.