Question

1. What is the importance of time horizon and confidence level in estimating VaR?
2. Explain the role of VaR in the collapse of LTCM.

Answer 1

a.The potential loss that is estimated through VaR depends on two most important exogenous variables i.e. time horizon and confidence level. Time horizon is important to determine the loss in the market value over the time horizon i.e. either daily, monthly or over a year. Confidence level is used to measure the degree of certainity in the VaR estimate. The degree of confidence is the level at which the investor or organization is certain that it will not suffer any losses. For example a 99% confidence level is to indicate that the investor is 99% sure that his losses from the portfolio will not exceed lets say $1000.

b. LTCM the world's largest hedge fund collapsed due to poor management of money and risk. The company used a combination of VaR estimates to mitigate and predict risks. The VaR estimates used by the fund predicted that the investors would not lose not more than 5 percent in a month in 5 , a loss of 10% in month in 10 meaning that the fund would not lose more than 20 percent of its portfolio in a year. It predicted that the situation of loss is very unlikely. The company relied on historical data to to predict future stock prices which later out to be disastrous. In the year 1998 a turn of events took place and the stock prices were beyond the predictive abilities of VaR trigerring a liquidity crisis in the global financial markets. LTCM's VaR estimates however continued to predict that the company will not lose more than 50 million of capital but the company continued to have losses of around USD 100 million each day. The fund infact lost USD 500 million of in a single day of trade and eventually declared bankruptcy. The fund excessively relied on VaR to estimate losses and risks and assumed that the volatility would remain constant throughout. VaR has to be used judiciously since this model does not factor in liquidity risk. It always assumes that normal market conditions will prevail which is not the case.