Value at risk basically measures the risk of loss of all the investment. So, if there is value at risk of 1% for one million dollars for the year, it means there’s 1% chance you’ll lose one million dollars for the year. It is a statistic that quantifies the extent of potential loss within a defined time frame. Value at risk or VaR is commonly used by risk managers to control and measure risk exposure and investment banks use it to determine the potential losses. Let’s look at more complicated example: A firm may determine that a portfolio has 10% 1 year VaR of 20%. This means that there is 10% chance for the portfolio to lose 20% of its value within the year. VaR is a common number that is used by institutions to determine if they will have enough capital on hand to cover losses or similar.
You can calculate VaR in three different ways, the variance covariance method, monte carlo method, and the historical method. The variance co variance method is great for risk measurement in which distributions are already known or estimated and the monte carlo method is used when probability distribution for risk factors is known. There isn’t a standard way to determine asset or portfolio using VaR and the statistics may be unreliable and may understate potential for risk events like the black swan.
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