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VaR

VaR or Value at Risk is a measure of market risk, most often used in the hedge fund world. It tries to put a value on potential losses within a portfolio based on a “normal” level of market movements, say those that will occur 95% of the time, though the definition of normal can change according to who is calculating the VAR – 99% is also often used. Since you are looking at the probability of something happening, it’s also important to think about the time period – so you might have more confidence that something is unlikely to happen tomorrow than saying something might happen at some point over the next year.

The VaR can be calculated based on historical market movements on an investment, on a delta normal basis (which uses the standard deviation of returns) or using a Monte Carlo simulation (plugging many possible outcomes into a model).

The VaR idea is essentially a backward looking measure. It is also trying to estimate what is happening 95% or 99% of the time which is great until you hit the other 5%/1% – it has been described as  “an airbag that works all the time, except when you have a car accident.”

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