In: Finance
Company A asked you to estimate the Value at Risk (VAR) for receivables from Vietnam and Singapore. Please describe in detail to Mr. AA what VAR measures and detail the process you would undertake to estimate VAR for Siam Cement. Please also include the potential drawbacks of the VAR method and what steps you would undertake to mitigate these drawbacks.
VAR or Value at risk is a summary measure of downside risk expressed in the reference currency. A general definition is: VAR is the maximum expected loss over a given period at a given level of confidence. VaR does not inform on the size of loss that might occur beyond that confidence level.The method used to calculate VaR may be historical simulation (either based on sensitivities or full revaluation), parametric, or Monte Carlo simulation. All methodologies share both a dependency on historic data, and a set of assumptions about the liquidity of the underlying positions and the continuous nature of underlying markets. In the wake of the current crisis the weaknesses of VAR methodology became apparent and they need to be addressed.
Methods of Calculating VAR
Institutional investors use VAR to evaluate portfolio risk, but in this introduction, we will use it to evaluate the risk of a single index that trades like a stock: the Nasdaq 100 Index, which is traded through the Invesco QQQ Trust. The QQQ is a very popular index of the largest non-financial stocks that trade on the Nasdaq exchange
1. Historical Method
The historical method simply re-organizes actual historical returns, putting them in order from worst to best. It then assumes that history will repeat itself, from a risk perspective.
2. The Variance-Covariance Method
This method assumes that stock returns are normally distributed. In other words, it requires that we estimate only two factors - an expected (or average) return and a standard deviation - which allow us to plot a normal distribution curve
3. Monte Carlo Simulation
The third method involves developing a model for future stock price returns and running multiple hypothetical trials through the model. A Monte Carlo simulation refers to any method that randomly generates trials, but by itself does not tell us anything about the underlying methodology.
The Bottom Line
Value at Risk (VAR) calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. We looked at three methods commonly used to calculate VAR. But keep in mind that two of our methods calculated a daily VAR and the third method calculated monthly VAR. In Part 2 of this series, we show you how to compare these different time horizons.
VaR Methodologies: comparative analysis
Addressing the limitations
Where these limitations may cause a material inaccuracy of VaR results, additional measures should be taken including one or more of the following:
1. the prompt review & correction of time series data used as an input to the VaR Model,
2. a VaR Add-on using a methodology that addresses the weakness,
a) the implementation of an appropriate full revaluation stress test,
b) the implementation of full revaluation or an alternative VaR methodology at a portfolio level (e.g. Monte Carlo simulation)
c) Market risk limit monitoring.
A VAR system alone will not be effective in protecting against market risk. It needs to be used only in combination with limits both on notional amounts and exposures and, in addition, should be reinforced by vigorous stress tests.