Value at Risk (VaR)

A dollar measure of the minimum loss that wolud be expected over a period of time with a given probability.

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The basic idea behind VAR is to determine the probability distribution of the underlying source of risk and to isolate the worst given percentage of outcomes. Using 5 percent as the critical percentage, VAR will determine the 5 percent of outcomes that are the worst. The perfomance at the 5 percent mark is the VAR.

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VaR for normally distributed change in portfolio value with zero expected change

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Estimating VaR

- The historical method

- The variance-covariance method (the analytical method)

- The Monte Carlo method

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VAR is most beneficial in communicating information.

Most banking regulators use VAR as a measure of the risk of a bank.