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80-20 Rule
Application of VaR
Standard Deviation
Correlation Coefficient
Glossary
The most popular and traditional measure of risk isvolatility as it doesnt care about the
direction of an investment's movement.
For investors, risk is about the odds of losing money, and VaR is based on that common-sense
fact. By assuming investors care about the odds of a really big loss, VaR answers the
question, "What is my worst-case scenario?" or "How much could I lose in a really bad month?"
VaR statistic has three components: a time period, a confidence level and a loss amount (or
loss percentage). Keep these three parts in mind as we give some examples of Variations of
the question that VaR answers:
What is the most I can - with a 95% or 99% level of confidence - expect to lose in dollars over the next month?
What is the maximum percentage I can - with 95% or 99% confidence - expect to lose over the next year?
You can see how the "VaR question" has three elements: a relatively high level of confidence
(typically either 95% or 99%), a time period (a day, a month or a year) and an estimate of
investment loss (expressed either in dollar or percentage terms).
There are two methods to identifying VaR First is Historical Returns. The historical
method simply re-organizes actualhistorical returns, putting them in order from
worst to best.
The QQQ started trading in Mar 1999, and if we calculate each daily return, we
produce a rich data set of almost 1,400 points. For example, at the highest point of
the histogram, there were more than 250 days when the daily return was between
0% and 1%. At the far right, you can barely see a tiny bar at 13%; it represents the
one single day (in Jan 2000) within a period of five-plus years when the daily return
for the QQQ was a stunning 12.4%!
Noticethe red bars. These are the lowest 5% of daily returns. The red bars run from
daily losses of 4% to 8%. Because these are the worst 5% of all daily returns, we can
say with 95% confidence that the worst daily loss will not exceed 4%. Put another
way, we expect with 95% confidence that our gain will exceed -4%. That is VAR in a
nutshell.
With95% confidence, we expect that our worst daily loss will not exceed
4%.
If we invest $100, we are 95% confident that our worst daily loss will not
exceed $4 ($100 x -4%).
You can see that VAR indeed allows for an outcome that is worse than a return of
-4%. It does not express absolute certainty but instead makes a probabilistic
estimate. To increase our confidence, we need only to "move to the left" on the
same histogram, to where the first two red bars, at -8% and -7% represent the
worst 1% of daily returns:
With 99% confidence, we expect that the worst daily loss will not exceed 7% or, if
we invest $100, we are 99% confident that our worst daily loss will not exceed $7.
The 80-20 is a ironclad rule that states that 80% of outcomes can be
recognized to 20% of all causes for a given event. In business, the 80-20 is
often used to point out that 80% of a company's revenue is generated by 20%
of its total customers. Therefore, the rule is used to help managers identify
and regulate which operating factors are most important and should receive
the most attention, based on an efficient use of resources.
STANDARD DEVIATION
The Standard
deviation
NORMAL CURVE
Confidenc
e
# of
Standard
Deviations(
)
95% (high)
- 1.65 x
99% (really
high)
- 2.33 x
Confidenc
e
# of
Calculatio
n
Equals
95% (high)
- 1.65 x
- 1.65 x
(2.64%) =
-4.36%
99% (really
- 2.33 x
high)
- 2.33 x
(2.64%) =
-6.15%
If a calculated correlation is greater than 1.0 or less than -1.0, a mistake has
been made.
VAR is just one numbergiving you arough ideaabout theextent of risk in the portfolio. Value At Risk is
measured in price units(dollars, euros) or aspercentage of portfolio value. This makes VAR very easy to
interpret and to further use in analyses, which is one of the biggestadvantages of Value At Risk.
You can measure andcompare VAR of different types of assetsand various portfolios. Value At Risk is
applicable to stocks, bonds, currencies, derivatives, or any other assets with price. This is why banks
and financial institutions like it so much they cancompare profitability and risk of different unitsand
allocate risk based on VAR (this approach is calledrisk budgeting).
Value At Riskis a frequent part ofvarious types of financial software. For example, you can
quicklycalculate Value At Riskof your portfolio on Bloomberg after entering holdings and setting a few
parameters. You dont have to be a statistics wizard to do this, as the software takes historical data of
securities in the portfolio and performs all calculations for you. Availability is a bigadvantage of VAR.
APPLYING VaR
Investment banks commonly apply VaR modeling to firm-wide risk due to the
possibility for independent trading desks to expose the firm to highly
correlated assets unintentionally.
Ignores the fact that some markets converge with time or have patterns, such as mean
reversion
Based on historical information (i.e. assumes that history will repeat itself)
Ignores the 0key risk associated with our hard assets (e.g. mines, mills, plants)
QUESTIONS
GLOSSARY