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Tutorial |
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| Value
at Risk (VaR) |
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| Goal |
To explain the concept of Value at Risk (VaR), and illustrate
how it can be used to analyze the risk level of a portfolio.
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| Definition |
A
measurement
of risk in terms of potential future financial loss on your
current investment portfolio; Represents the worst-case
future financial loss you can expect to incur on
that portfolio within a given timeframe (95% confidence level).
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| How it works |
VaR is one of the most important risk
measurements used by major financial institutions that presents risk in terms of
potential financial loss on your portfolio. VaR draws on statistics to
translate portfolio volatility into an actual value, which represents (with 95%
confidence) the most money your portfolio is likely to lose within a given
timeframe in the future. As a tool, VaR is very useful for comparing
your portfolio with the market portfolio (S&P 500).
Of course, since VaR is presented "with 95% confidence", this
implies that you can pessimistically anticipate maximum future losses exceeding
a VaR amount 5% of the time within a given timeframe.
Note: In general, a portfolio with low return volatility and low
correlation between individual assets will have a low
VaR.
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| A Practical
Example |
In the chart below, we have a user portfolio and
the S&P 500 portfolio. While both portfolios have equal market values,
the user portfolio's higher VaR numbers indicate that it carries significantly
more risk than the S&P 500 portfolio.
For example, we can say with 95% confidence that on any given day in the
future, the currently-held user portfolio could lose up to $1,159, and the
S&P 500, up to $776. Since the user portfolio's daily VaR is presented
"with 95% confidence", our user must understand that on any given day
in the future there is a 5% probability of maximum financial loss exceeding
$1,159.
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User Portfolio |
S&P 500 Portfolio |
Market Value of Portfolio
(as of latest market closing) |
$95,910 |
$95,910 |
| Daily Value at Risk |
$1,159 |
$776 |
| Monthly Value at Risk |
$5,311 |
$3,557 |
| Annual Value at Risk |
$18,399 |
$12,322 |
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| Conclusion |
VaR is one of several important measurements that you can
use to analyze and assess the risk level of your investment portfolio.
FinPortfolio recommends using VaR together with Risk-Adjusted Return and Market
Risk Exposure in order to form a comprehensive view of your portfolio's
risk.
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| Relevant Links |
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