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# VALUE AT RISK

80-20 Rule

## Methods on how to calculate VaR

Application of VaR

## The Formulas for VaR

Standard Deviation

Correlation Coefficient

Glossary

## THE IDEA OF VaR

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
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).

## VaR is a statistical technique used to measure and quantify the level of

financial risk within a firm over a specific time frame.

## This metric is most commonly used by investment and commercial banks to

determine the extent and occurrence ratio of potential losses in their
institutional portfolios.

## calculations can be applied to specific positions or portfolios as a whole or to

measure firm-wide risk exposure.

## METHODS ON HOW TO CALCULATE VaR

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 PARETO PRINCIPLE (80-20) RULE

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

## Standard deviation is a measure of

thedistributionof a set of data from its mean.
If the data points are further from the mean,
there is higher deviation within the data set.
Standard deviation is calculated as the square
root of variance by determining the variation
between each data point relative to the mean.

## If broken down, in finance, standard deviation

is applied to the annualrate of returnof an
investment to measure the investment's
volatility. Standard deviation is a statistical
measurement that sheds light on
historical volatility. For example, a volatile
stock has a high standard deviation, while the
deviation of a stableblue-chipstock is lower. A
large dispersion indicates how much the return
on the fund is deviating from the expected
normal returns.

The Standard
deviation

DEVIATION

NORMAL CURVE

## The normal distribution, also known as the Gaussian or standard normal

distribution, is theprobability distributionthat plots all of its values in a
symmetrical fashion, and most of the results are situated around the
probability's mean. Values are equally likely to plot either above or below the
mean. Grouping takes place at values close to the mean and then tails off
symmetrically away from the mean.

## This method assumes that stock returns are

normally distributed. So it requires that we
estimate only two factors - an average return and
astandard deviation- which allow us to plot
anormal distributioncurve.

Confidenc
e

# of
Standard
Deviations(
)

95% (high)

- 1.65 x

99% (really
high)

- 2.33 x

## daily standard deviation of the QQQ, which is

2.64%. The average daily return happened to be
fairly close to zero, so we will assume an
average returnof zero for demonstrative
purposes. Here are the results of plugging the
actual standard deviation into the formulas
above:

## The idea behind the variance-covariance is similar

to the ideas behind the historical method - except
that we use the familiar curve instead of actual
data. The advantage of the normal curve is that
we automatically know where the worst 5% and 1%
lie on the curve. They are a function of our
desired confidence and the standard deviation ():

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%

## The correlation coefficient is a measure that determines the degree to which

two variables movements are associated.

## The range of values for the correlation coefficient is -1.0 to 1.0.

If a calculated correlation is greater than 1.0 or less than -1.0, a mistake has

## A correlation of -1.0 indicates a perfectnegative correlation, while a

correlation of 1.0 indicates a perfectpositive correlation.

COEFFICIENT

## Comparing VAR of different assets and portfolios

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).

## VAR is often available in financial software

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.

## Using a firm-wide VaR assessment allows for the determination of the

increasing risks from combined positions held by different trading desks and
departments within the organization.

## Utilizing the data provided by VaR modeling, financial organizations can

determine whether they have adequate capital reserves in place to cover
losses or whether higher-than-acceptable risks need focused on holdings to be
reduced.

## Ignores the tradeoff between risk and return

Ignores the fact that some markets converge with time or have patterns, such as mean
reversion

## Ignores fat tails

Based on historical information (i.e. assumes that history will repeat itself)

## Longer term perspective

Ignores the 0key risk associated with our hard assets (e.g. mines, mills, plants)

QUESTIONS

GLOSSARY

## Historical Volatility- is the realizedvolatilityof afinancialinstrument over a given time

period. Generally, this measure is calculated by determining the average deviation from
the average price of afinancialinstrument in the given time period.

## Rate of return- is the gain or loss on aninvestmentover a specified time period,

expressed as a percentage of theinvestment'scost. Gains on investments are definedas
income received plus any capital gains realized on the sale of the investment.

## Historical returns- Is the past performance of a security or index.Analystsreview

historical return data when trying to predict future returns, or to estimate how a
security might react to a particular situation, such as a drop in consumer demand.
Historical returns can also be useful when estimating where future points of data may
fall in terms ofstandard deviations.