The two concepts that make up value-at-risk and market risk management are extremely useful when it comes to managing investments. Value at risk is calculated by subtracting the asset’s current market price from the total value of the holdings. Because the calculation uses the total market price of the item, not just the current market price, it has the advantage of giving a more accurate picture of what a particular investment would likely be worth given a variety of different circumstances. Market risk, on the other hand, involves all the factors that go into the calculation of the price of an asset. It is basically the impact that changes in market prices will have on that asset’s value. Both concepts can help managers and investors keep track of how valuing their portfolios is doing.
Value-at-risk calculations are important to anyone who manages a portfolio that contains CDs. Without them, investors would not be able to calculate the potential recovery of the principal balance they have invested in each quarter. In order to determine the amount of premium they should charge, many investment banks and financial institutions use value-at-risk calculations to gauge the performance of their investment portfolios.
Some investors may view this type of risk as an unnecessary intrusion into their carefully constructed financial portfolio. After all, how does a bank decide how much to pay a defaulting customer if it doesn’t even know what the default might be? However, market risk management is not just about evaluating risk-a key part of market risk management involves evaluating portfolio vulnerability to unexpected events. Default rates can’t always be predicted; in fact, none can yet every investor must account for the possibility of significant losses. To do this, many investors make use of market risk management techniques such as credit default swaps and interest rate risk management.
One example of using risk management to reduce the inherent risk in an investment portfolio is to replace the portfolio’s component investments with one instrument only: cash. By doing so, the portfolio’s overall risk is reduced by one third. Cash instruments are less risky than stocks, options, bonds, and other common investments and they provide a flexible way to move funds between various assets and markets. The use of cash instruments for allocating risks reduces the need for valuing the individual components of the portfolio, and since the instruments are often of greater size and have higher market liquidity, they allow more accurate evaluation of portfolio risk.
There are two types of risk measure that are used by today’s Value At Risk (VaR) applications. One of these is the one-year VaR, which evaluates the loss value of a portfolio over one year, or a one-year period. The second type of measure is the five-year or ten-year VaR, which evaluates the loss value over a minimum of five years. These two types of measurements are the basis for standardizing the VaR approach.
In general, the calculation of value-at-risk (VaR) involves the study of risk by identifying and describing the potential losses that occur in response to changes in the underlying portfolio, financial market, or business. Although the expression “risk” is often associated with the word “risk” and can therefore be used as a definition of the concept of risk management, the actual definition of risk management is much more complex and includes many different concepts and assumptions. Many investors are familiar with the term “risks” and how this relates to their traditional risk management framework, but they may not understand how this risk measurement and its various assumptions actually interact and interrelate within the VAR framework.
Value At Risk (VaR) is based on a set of economic or practical assumptions regarding future market performance, which can often vary significantly from the underlying investment portfolio. This is why the value-at-risk calculation is not necessarily the same across all financial risk measures. For instance, while some managers may view short-term liabilities as a lower risk than long-term liabilities, others may view medium- and long-term assets as a higher risk than inventory, and yet others may view bond issuance as a higher risk than buying stocks. Because of this wide-ranging interpretation of risk and the different assumptions upon which it is measured, the calculation of value-at-risk is very difficult to standardize, which makes it especially challenging to use as a basis for comparison between various types of financial risk measures.
To facilitate discussion, we will describe some common assumption types and an illustration of how each of them may be used in a standard financial risk measure. The most common type of risk assessment is the historical simulation. Historical simulation is a best-of-all-world approach that takes into account not only the present but also possible future scenarios of return and price of selected investments. It takes into account not only the present value of the portfolio, but also its probable return. Historical simulation is most useful for computing a portfolio equity multiple times with all of its variables updated, such as price, risk, and reinvestment. Standard deviation is another common assumption type and is used in the historical simulation.