Value At Risk - VaR

A good attitude to have in life, and in portfolios, is to hope for the best, but prepare for the worst. Calculating your VaR, or your value at risk, is for the latter part.

VaR measures the potential loss that could theoretically happen to your portfolio (or a specific investment) in a certain timeframe. To calculate your VaR, you’ll have to pick a timeframe and a confidence level, which will result in a potential loss amount. While that may sound like a nice-to-have figure for your individual self, it’s a really important factor in determining how much in liquid reserves to have on hand for financial institutions. Having not enough reserves on hand when the worst-case-scenario becomes reality could mean the death of a financial institution (unless Ben Bernanke is the Fed Chair).

But how do you know how much you could potentially lose? Some prefer to use the historical method, using past data trends on those securities. Others think that generalizing the past isn’t a good indicator for what could happen in the future, preferring to use the statistical variance method, assuming returns are normally distributed. Some think both of those ideas aren’t great, since returns may not be normally distributed, so it’s best to come up with your own model via the Monte Carlo method.

Whatever method used, banks use it often. They check and recheck that they didn’t accidentally take on too much risk with all the investment hubbub happening on the reg.