VAR is widely used and has both advantages and disadvantages
Value At Risk, known as VAR, is a common tool for measuring and managing risk in the financial industry. While there are several advantages which have led to big popularity of VAR, anybody using it should also understand the limitations of Value At Risk as a risk management tool.
Value At Risk interpretation
Value At Risk is a number, measured in price units or as percentage of portfolio value, which tells you that in a defined large percentage of cases (usually 95% or 99%) your portfolio is likely to not lose more than that amount of money. Or said the other way around, in a defined small percentage of cases (5% or 1%) your loss is expected to be greater than that number.
Following are some of the advantages of Value At Risk as a risk management tool.
Value At Risk is easy to understand
VAR is just one number giving you a rough idea about the extent of risk in the portfolio. Value At Risk is measured in price units (dollars, euros) or as percentage of portfolio value. This makes VAR very easy to interpret and to further use in analyses, which is one of the biggest advantages of Value At Risk.
Comparing VAR of different assets and portfolios
You can measure and compare VAR of different types of assets and various portfolios. Value At Risk is applicable to stocks, bonds, currencies, derivatives, or any other assets with price. This is why banks and financial institutions like it so much – they can compare profitability and risk of different units and allocate risk based on VAR (this approach is called risk budgeting).
The limitation of Value at Risk as a risk budgeting tool is the fact that VAR is not easily additive. VAR of a portfolio of two assets does not necessarily equal the sum of the single asset VARs, as the correlations must also be taken into consideration.
VAR is often available in financial software
Value At Risk is a frequent part of various types of financial software. For example, you can quickly calculate Value At Risk of your portfolio on Bloomberg after entering holdings and setting a few parameters. You don’t have to be a statistics wizard to do this, as the software takes historical data of securities in the portfolio and performs all calculations for you. Availability is a big advantage of VAR.
Everybody else uses VAR
Though there are different opinions regarding whether its popularity is justified (see limitations), Value At Risk is considered the gold standard, the part of risk management 101 in financial institutions. Of course, when your competitors use it, your clients require it, and regulators recommend it, you have big reasons for using VAR too.