I am “X” percent certain there will not be a loss of more than “V “in the next “N” days

X is the confidence levelV is the VAR of the portfolioN is the time horizon

A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame. Value at risk is used by risk managers in order to measure and control the level of risk which the firm undertakes.

Value at Risk is measured in three variables: the amount of potential loss, the probability of that amount of loss, and the time frame. For example, a financial firm may determine that it has a 5% one month value at risk of $100 million. This means that there is a 5% chance that the firm could lose more than $100 million in any given month. Therefore, a $100 million loss should be expected to occur once every 20 months.

ANALYTICAL METHOD HISTORICAL METHOD MONTE CARLO SIMULATION METHOD

ANALYTICAL METHOD

Variance- covariance method Knowledge of input values Under the assumptions of normal distribution

HISTORICAL METHOD

Estimates the distribution of the portfolio performance by collecting data on the past performance of the portfolio and using it to estimate the future probability distribution

Produces a VAR that is consistent with the VAR of the chosen historical period

MONTE CARLO SIMULATION METHOD

Named for the city of “MONTE CARLO” which is known for casino’s.

Simulation is a procedure in which random numbers are generated and the outcomes associated with these random drawings are then analyzed to determine the likely results and the associated risk.

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