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[size=+1]A popular measure of risk in the financial industry is value at risk (VaR). Some investors have begun to question its appropriateness as they experience losses in their investments exceeding their VaR estimates. Measurisk, LLC, a J.P. Morgan company, has developed methodologies for computing VaR for portfolios and highlights in this article that the issue may not be with VaR, but rather how it is used and interpreted.


[size=+1]Probability of High Losses
VaR is not a measure of maximum potential loss; nor is it a guarantee that investors are unlikely to lose more. By definition, a one-month, 95% confidence VaR indicates a 5% probability of next month’s losses exceeding the VaR estimate—not zero, as some unfamiliar with VaR often believe. Over longer periods, investors should expect that VaR will be breached once or even multiple times. It is thus helpful to assess the probabilities for breaches for the 95% confidence interval over a period of 12 months.
Probabilities of losses exceeding a 95% confidence monthly VaR:
• One or more breaches in a given year: 46%
• Two or more breaches in a given year: 12%
• Three or more breaches in a given year: 2.1%
Over time, investors should expect losses to exceed a VaR estimate. Even increasing the VaR to 99% still shows that there is a 0.6% chance of having two or more breaches of the 99% VaR over 12 months.


[size=+1]A Market Tail Event
In the past few months, we have seen a one-day drop of 24% in the Dow, which has only occurred eight times in its history. Investors should not be surprised that funds are experiencing losses that exceed their 95% or even 99% VaR. In the current environment, investors should monitor a 99.5% or even 99.9% VaR as a more realistic measure of risk.
It is also important to understand that a loss one month does not make a loss less likely the next month. So, several losses during a short period of time are possible without a single breach of VaR.


[size=+1]Summary
VaR is a powerful tool for evaluating risk, but it is critical to fully understand its meaning and possible limitations. VaR should not be viewed as an unlikely loss. Unfortunately, one or even multiple VaR breaches could occur in a given year, especially when markets experience their own tail events. If the loss associated with the VaR number, or multiple months of losses near or exceeding VaR, is unacceptable, then the portfolio VaR should be reduced such that two or three times VaR is more acceptable as a possible loss.

In difficult market conditions, investors need to use a variety of tools to properly monitor risks and exposures. Fortunately, the steps and information necessary to calculate VaR using current positions also provide the foundation for other measures, including historical stress testing, risk factor sensitivity analysis and exposure concentration analysis. These measures can help investors gauge performance in extreme markets. A strong investment process is most often built around a strong risk process. Using VaR and its related measures will continue to serve investors well in these trying conditions.

Source:　ＪＰ　Ｍｏｒｇａｎ