Question

Discuss the three main criticisms of Value-at-Risk as a risk measure that were outlined in lectures. Suggest one idea that could be implemented to address at least one criticism

Answer 1

Value added Risk is compared to "an airbag that works all the time, except when you have a car accident."

The major criticism of VaR is:

• Led to excessive risk-taking and leverage at financial institutions
• Focused on the manageable risks near the center of the distribution and ignored the tails
• Created an incentive to take "excessive but remote risks"
• Was "potentially catastrophic when its use creates a false sense of security among senior executives and watchdogs."

The methods used for calculating VaR actually hold the key to the reliability of the estimate. Also various methods can be used to calculate the possible value at risk on the same time horizon, depending on the availability of the data.

For example: If VaR is calculated for a very short horizon, say intraday, amount of data may be too small to provide a consistent or reliable answer, but it may not be possible to include additional actual data (due to trade changes or other restrictions). In such cases sample size has to be artificially increased using methods of re-sampling to create enhanced view of the current situation and increase the reliability of the VaR.

Methods to Calculate VaR: Starting from the basic methods we shall move to more complex ones, readers should keep in mind that the examples provided in the article do not constitute any advice or a real life scenario. They are meant only to provide a basic understanding and general idea about the framework of VaR calculations. Real life solutions may be a lot more complex.