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Value At Risk is easy to understand

VAR is just one number giving you a rough idea about the extent of risk in the portfolio.
Value At Risk is measured in price units (dollars, euros) or as percentage of portfolio value.
This makes VAR very easy to interpret and to further use in analyses, which is one of the
biggest advantages of Value At Risk.

Comparing VAR of different assets and portfolios

You can measure and compare VAR of different types of assets and various portfolios. Value
At Risk is applicable to stocks, bonds, currencies, derivatives, or any other assets with price.
This is why banks and financial institutions like it so much ± they can compare profitability
and risk of different units and allocate risk based on VAR (this approach is called risk
budgeting).

The limitation of Value at Risk as a risk budgeting tool is the fact that VAR is not easily
additive. VAR of a portfolio of two assets does not necessarily equal the sum of the single
asset VARs, as the correlations must also be taken into consideration.

VAR is often available in financial software

Value At Risk is a frequent part of various types of financial software. For example, you can
quickly calculate Value At Risk of your portfolio on Bloomberg after filling out holdings and
setting a few parameters. You don¶t have to be a statistics wizard to do this, as the software
takes historical data of securities in the portfolio and performs all calculations for you.
Availability is a big advantage of VAR.

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Value At Risk can be misleading: false sense of security
Looking at risk exposure in terms of Value At Risk can be very misleading. Many people
think of VAR as ³the most I can lose´, especially when it is calculated with the confidence
parameter set to 99%. Even when you understand the true meaning of VAR on a conscious
level, subconsciously the 99% confidence may lull you into a false sense of security.

Unfortunately, in reality 99% is very far from 100% and here¶s where the limitations of VAR
and their incomplete understanding can be fatal.

VAR does not measure worst case loss

99% percent VAR really means that in 1% of cases (that would be 2-3 trading days in a year
with daily VAR) the loss is expected to be greater than the VAR amount. Value At Risk does
not say anything about the size of losses within this 1% of trading days and by no means does
it say anything about the maximum possible loss.

The worst case loss might be only a few percent higher than the VAR, but it could also be
high enough to liquidate your company. Some of those ³2-3 trading days per year´ could be
those with terrorist attacks, Kerviel detection, Lehman Brothers bankruptcy, and similar
extraordinary high impact events.

You simply don¶t know your maximum possible loss by looking only at VAR. It is the single
most important and most frequently ignored limitation of Value At Risk.

Besides this false-sense-of-security problem, there are other (perhaps less frequently
discussed but still valid) limitations of Value At Risk:

Value At Risk gets difficult to calculate with large portfolios

When you¶re calculating Value At Risk of a portfolio, you need to measure or estimate not
only the return and volatility of individual assets, but also the correlations between them.
With growing number and diversity of positions in the portfolio, the difficulty (and cost) of
this task grows exponentially.

The resulting VAR is only as good as the inputs and

assumptions
As with other quantitative tools in finance, the result and the usefulness of VAR is only as
good as your inputs. A common mistake with using the classical @ariance-co@ariance Value
At Risk method is assuming normal distribution of returns for assets and portfolios with non-
normal skewness or excess kurtosis. Using unrealistic return distributions as inputs can lead
to underestimating the real risk with VAR.

Different Value At Risk methods lead to different results

There are several alternative and very different approaches which all eventually lead to a
number called Value At Risk: there is the classical variance-covariance parametric VAR, but
also the Historical VAR method, or the Monte Carlo VAR approach (the latter two are more
flexible with return distributions, but they have other limitations). Having a wide range of
choices is useful, as different approaches are suitable for different types of situations.
However, different approaches can also lead to very different results with the same portfolio,
so the representativeness of VAR can be questioned.

The 



Value-at-risk models cannot precisely model the true value that is at risk during times of
market collapse, chaos and severe duress. Lots of money, time and effort is put towards these
mathematically flawed risk management models when basic common sense and experience
are known to achieve better results than these complicated systems.

The  



Nevertheless, one of the major benefits to this model is that it¶s able to quantify to a degree of
probability or percentage the dollar amount at risk in a certain portfolio. This affords top-
level management a bird¶s eye view of one of a series of metrics in order to validly interpret
the balance, risk and overall efficiency of a portfolio. It¶s up to management and experienced
professionals to make informed decisions about the overall trend in the markets and what can
be expected given certain scenarios. The value-at-risk metric is just one more valuable metric
for their analytical database and should not be viewed as the be all and end all for bulletproof
risk management.

VaR is pervasive, used by all the trusted banks. Because of the controversy surrounding the
financial debacle in 2008, this risk management model has been under a great deal of
scrutiny. It is known to be flawed; the statistical kurtosis of the financial markets is much
higher than that of a normally distributed series. Proponents of the model know to adjust it in
order to better model the markets realistically. However, if these models are more frequently
being adjusted to fit the data, there must be a fundamental flaw within the theory of the model
itself. Yet, there is not much of a replacement for value at risk. Those who know best know to
use the model cautiously.