Using Value at Risk to Manage Your Portfolio

Value at Risk

Risk management is a framework for describing the depth of risk exposure within a portfolio of assets.  Defining the risk management is generally a customized process, and using tools that describe the volatility of the returns is essential toward understand the capital at risk in a desired portfolio.  One of the most widely used metrics is the “value at risk” calculation which describe the amount of capital that can be gain or lost give a specific gyration in a portfolio.

Measuring Value at Risk

There are three basic methods used to determine VAR, along with a plethora of variations on those basic approaches.   An analytical solution can be used by measuring the variances within a portfolio. Var can also be estimated by running historical data analysis or from Monte Carlo simulations.

Monte Carlo simulation is the random sampling of values in a time series. Monte Carlo methods are often used in simulating physical and mathematical systems.

Drawbacks of Value at Risk

While Value at Risk has acquired a strong following in the risk management community, there is reason to be skeptical of both its accuracy as a risk management tool and its use in decision taking. There are many dimensions on which researcher have taken issue with VaR.

There is no precise measure for Value at Risk, and each measure comes with its own limitations. Value at risk can be the wrong approach for certain portfolios. Liquidity along with lack of specific data can generate varying results.  Every calculation makes an assumption about future outcomes.  Value at risk generally deals with normally distributed instruments.   When using historical simulations, the assumption is that the past reflects events in the future, but as seen with the recent financial crisis that is not always the case.

History may not a good predictor and even simulation use some kind of historical data as a way of generating future data points.

Narrow Definition

Value at risk has a narrow definition and fails to incorporate numerous other issues related to risk management. Using VAR the only measure of risk can create a false sense of security about the positions held within a portfolio.

 

Risk Analysis

Value at Risk measures the likelihood of losses to an asset or portfolio due to market risk. This is a narrow definition, which excludes credit risks and liquidity risk. Additionally, VAR is only looked at as a negative, which eliminates positive outcomes. A more potent estimate of risk could be achieved if political risk, liquidity risk and regulatory risks where incorporated into the calculation

Summary

Value at risk is widely used within the risk management industry, as a benchmark to gauge market risk.  With its numerous drawbacks, it is only one of the risks used by investors to measure the risk of a portfolio.  Risks related to the beta of a portfolio along with benchmarking the returns are not incorporated into a standard VAR model.  Given its wide breath it is important to understand the value of the calculation along with its abilities to assist in measuring a portfolios exposure.