Discuss Risk management and derivatives.
Value at risk(VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by firms and regulators in the financial industry to gauge the amount of assets needed to cover possible losses.
For a given,, andp, thepVaR can be defined informally as the maximum possible loss during that time after excluding all worse outcomes whose combined probability is at mostp. This assumespricing, and no trading in the portfolio.
For example, if a portfolio of stocks has a one-day 95% VaR of $1 million, that means that there is a 0.05 probability that the portfolio will fall in value by more than $1 million over a one-day period if there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day out of 20 days (because of 5% probability).
More formally,pVaR is defined such that the probability of a loss greater than VaR is (at most)(1-p)while the probability of a loss less than VaR is (at least)p. A loss which exceeds the VaR threshold is termed a “VaR breach”.
It is important to note that, for a fixedp, thepVaR does not assess the magnitude of loss when a VaR breach occurs and therefore is considered by some to be a questionable metric for risk management. For instance, assume someone makes a bet that flipping a coin seven times will not give seven heads. The terms are that they win $100 if this does not happen (with probability 127/128) and lose $12,700 if it does (with probability 1/128). That is, the possible loss amounts are $0 or $12,700. The 1% VaR is then $0, because the probability of any loss at all is 1/128 which is less than 1%. They are, however, exposed to a possible loss of $12,700 which can be expressed as thepVaR for anyp 0.78125% (1/128).
VaR has four main uses in:, financial,and computing. VaR is sometimes used in non-financial applications as well.However, it is a controversial risk management tool.