While you are hoping for positive returns from your investment portfolio, you should not overlook the possibility of investment loss as well. Inability of preparing for the potential losses is usually the root cause of the collapse of some financial institutions and bankruptcy of an individual.
Value at Risk (VaR) is a statistical technique used to measure the potential risk of loss for investments. VaR analysis takes into account variables like market volatility, economic trends, and other key factors that can influence investment outcomes.
Value at Risk is measured in three parts – the amount of expected loss, time frame of the loss and the confidence level. Expected losses refers to how much an investment could lose within its given timeframe and certainty level. Quantifying the extent of potential loss requires specifying both its timeframe and severity; typically this period ranges between days, weeks and months with longer timespans suggesting greater losses.
The likelihood of loss, or certainty level, represents the probability that actual losses will fall below anticipated losses. An evaluation of downside risk- or likelihood of money loss- associated with investments or portfolios under normal and stressed market conditions.
For example, if the 5-day 99%VaR value of your investment portfolio is $100K, it suggests that the potential loss of your portfolio is unlikely (at 99% confidence level) to be more than $100K at a 5-day horizon.
VaR first emerged in the late 1980s when financial institutions like J.P. Morgan and Bankers Trust adopted it for internal risk management purposes. Industry-wide acceptance occurred after J.P. Morgan published RiskMetrics as a public methodology for calculating VaR.
Basel Committee on Banking Supervision recommended VaR models as regulatory market risk capital requirements. VaR became a standard risk management tool by the late 90s/early 2000s with various methodologies including historical simulation, parametric approaches and Monte Carlo simulation being developed by both academics and practitioners alike.