Question

In: Finance

Company A asked you to estimate the Value at Risk (VAR) for receivables from Vietnam and...

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.

Solutions

Expert Solution

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.


Related Solutions

Illustrate the difference between the value-at-risk (VaR) and conditional value-at-risk (C-VaR) measures
Illustrate the difference between the value-at-risk (VaR) and conditional value-at-risk (C-VaR) measures
1) A risk analyst is trying to estimate the credit VaR for a risky bond. The...
1) A risk analyst is trying to estimate the credit VaR for a risky bond. The credit VaR is defined as the maximum unexpected loss at a confidence level of 99.9% over a one-month horizon. Assume that the bond is valued at $1,000,000 one month forward, and the one-year cumulative default probability is 2% for this bond. What is the credit VaR for the bond, assuming no recovery? 2) Mr. Rosenqvist, asset manager, holds a portfolio of 100 million, which...
Describe some advantages and disadvantages of Value at Risk (VaR) as a risk measure relative to...
Describe some advantages and disadvantages of Value at Risk (VaR) as a risk measure relative to other risk measures
What are VaR (value at risk) models? How important are they? Do you think Mandelbrot or...
What are VaR (value at risk) models? How important are they? Do you think Mandelbrot or Malkiel would recommend them? Would you use them? How?
If a Normal distribution is assumed for the possible future outcomes, the Value at Risk (VaR)...
If a Normal distribution is assumed for the possible future outcomes, the Value at Risk (VaR) is fairly straightforward and simple to calculate if the mean and standard deviation are known. True False A fairly accurate estimate of the Value at Risk (VaR) can be determined by using the generally accepted assumption that daily returns of the stock market as measured by the S&P 500 Index are consistent with a Normal distribution. True False The Value at Risk (VaR) tells...
Discuss the main sources of risk in commercial banking, and critically discuss the Value-at-Risk (VaR) approach...
Discuss the main sources of risk in commercial banking, and critically discuss the Value-at-Risk (VaR) approach to risk measurement.
Value at Risk (VaR) is an attempt to provide a single number for senor management summarizing...
Value at Risk (VaR) is an attempt to provide a single number for senor management summarizing the total risk in a portfolio of financial assets. It has become widely used by corporate treasurers and fund managers as well as by financial institutions. A company currently has $5 million invested in commodity X and $3 million invested in commodity Y. The daily sigma of commodity X is 1 percent, the daily sigma of commodity Y is 1.5 percent, and the coefficient...
.p2(2) VaR (Value at Risk) is defined as ///////////////////////////////////// In words: The maximum loss over a...
.p2(2) VaR (Value at Risk) is defined as ///////////////////////////////////// In words: The maximum loss over a predetermined period with a confidence interval. formula : VaR=position * z * sigma where position : the value of your portfolio z : depends on the confidence interval =norm.inv(0.01,0,1)=-2.326347874 # for 99% =norm.inv(0.05,0,1)=-1.644853627 # for 95% sigma : the period standard deviation Assume that we have 100 shares of IBM stocks, 200 shares of Wal-Mart and 300 shares of Citi Group (ticker is C)....
You have been asked to estimate the value of a home for sale. The subject property...
You have been asked to estimate the value of a home for sale. The subject property has three bedrooms, one bathroom, and is in good condition. A highly comparable property just sold near the subject recently. You will use this recent sale as the comp to estimate value of of the subject property. The comp sold for $134,000. It has three bedrooms, two bathrooms, and is in good condition. Assume bedrooms are worth $5,000 and bathrooms are worth $3,000. What...
You have been asked to estimate the value of a home for sale. The subject property...
You have been asked to estimate the value of a home for sale. The subject property has three bedrooms, two bathrooms, and is in good condition. A highly comparable property just sold near the subject recently. The comp sold for $127,900. It has three bedrooms, one bathroom, and is in good condition. Assume bedrooms are worth $4,500 and bathrooms are worth $2,700. What is the indicated value of the subject based on the comparable sale? (please show all work below...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT