What is Value at Risk (VaR)?
Value at Risk (VaR) is a calculation of the potential loss that will occur when you buy an asset. This is a common term in the world of investing. Not only when you buy shares, but it can also be like buying property and so on. But you also need to know that Value at Risk is actually a general concept that can be applied to any number of things.
VaR is widely applied in finance to quantitative risk management for various types of risk. Value at Risk calculates the amount of potential loss that may occur in the company's portfolio. Potential loss is defined for a certain period of time. Value at Risk as the amount of risk loss is measured in absolute currency values. For example, daily VaR with a probability of 95% is 2.3 billion, meaning that in the next 20 days there is a potential loss of 2.3 billion.
There are several methods, in calculating Value at Risk , among others.
- Variance-covariance: is a method of calculating VaR that uses the assumption that all asset returns in the portfolio are normally distributed. In this method the VaR method requires standard deviation and convarince data from the assets compiling the portfolio.
- Historical simulation: is the basic method of non parametric approach (does not assume normal distribution). This method observes the return of the current portfolio for the past several times.
- Monte Carlo: is a calculation method that is almost similar to the variance-convariance method . However, in the Monte Carlo method, the parameters of a distribution are not calculated but are assumed.
Advantages of VaR
There are various advantages associated with using asset values to estimate risk. The first, which is easy to understand, gives us a number to indicate a certain level of risk. This also applies to a variety of assets, including stocks, bonds, currencies, and derivatives, meaning that various institutions can use them. Finally, it's important to remember that VaR is widely used, making it a good standard for buying or selling assets.
However, there are also some limitations associated with calculating VaR that we must understand. Most importantly, there is no standard protocol for determining company-wide assets / portfolios / risk, and it is possible that the statistics used in the value at risk formula end up understating or increasing the potential risk associated with the investment in question.
Potential Profits and Losses
By looking at the risk of loss and potential profit, investors can determine how much investment will be invested, what assets will be invested and also how long these assets will be maintained. Therefore, investors will calculate this carefully.
As long as the risk is still within the acceptable limit, investors will usually bet on the initial loss and hope for the next profit. Every business will go through this phase and if it fails in the early stages, then the company will close down and not thrive. If you pass the critical point, the profit will continue to be made.