What is VaR?

The recent soccer World Cup introduced Video Assistant Referees (VAR) – basic playback technology to verify decisions and to take the risk out of making incorrect conclusions. However, the acronym VaR was first coined long before FIFA thought of it.

To those involved in financial risk management VaR translates as Value at Risk. It is a calculation of the level and scope of financial risk being undertaken within a business or within an investment portfolio. The mathematical methodology is used to compute and quantify the risk over a particular time frame. The measure is most commonly used by banks, insurance companies and investment firms to determine the extent of potential financial losses. VaR helps them identify the extent of the potential risk; how much of the business value is at risk and the likelihood of risks impacting in a range of worsening circumstances.

VaR has had a chequered history. When it was first mooted it promised a risk measurement tool that was going to provide absolute certainty on the extent of the potential future downside risk. Ironically, the very over-reliance on VaR is one of the reasons why many financial institutions have had to bolster their capital positions following catastrophic losses to their investment portfolios. Given that most institutions adopted the VaR model its vulnerabilities were magnified. Its basic defect is that it cannot predict the future with certainty – and this point was lost on those who relied on VaR for precise risk measurement.

VaR concentrates on probabilities and the likelihood of extreme events happening. It provides a robust discipline of risk measurement and is itself, therefore, not open to subjectivity. However, the results of the VaR calculations are subject to assessment by internal risk managers. The VaR result might suggest that 2% of the firm’s capital is at risk if there is a fall of 20% in the value of its investment assets over the course of 3 months. The VaR calculation might go further and highlight that 10% of the capital is at risk if the markets fall by a further 20% in the following 3 months. But internal managers might decide that the historic incidence of two consecutive falls of 20% in two successive quarters is statistically very, very low and can, therefore, be safely discounted. And their assessment might well be correct!

The shock to the system arises when a freak event occurs – something that is outside standard probabilities – like two consecutive falls totalling 40% in 6 months. It is the job of risk managers to paint a bleak picture and to direct attention to the worst-case-scenario on the off chance that it might actually occur. Far too often other business managers dismiss this as outright negativity.

This is a mistake!

VaR has shown itself to have flaws and it certainly requires re-working as more unusual market variables appear more regularly. The concept is valuable and should not be shelved. However, managers outside of the risk sphere should be reminded that it’s not infallible.