Volume 3 Valuation and Risk Metrics © Copyright 2002, CCRO. All rights reserved. 10 3.0 Value at Risk (VaR) 3.1 Discussion of Metric1 The value at risk (VaR) of a position or a portfolio is the loss or change in value that is not expected to be exceeded with a given degree of confidence over a specified time period. VaR is therefore a statistical measure of variability in the value of a portfolio of positions or earnings from economic activity arising from the changes in the market prices of the commodities or other variables underlying the portfolio or activity. For example, a VaR value of $10 million at a confidence level of 99% and a holding period of 5 days using a one-tailed confidence level can be understood to mean the following: given the current structure of the market, one could say with a confidence level of 99% that over this period the loss in the value of the position/portfolio under consideration will not exceed $10 million. Equivalently, one can also say that there is a 1% probability that the actual loss over the liquidation period will exceed $10 million. The VaR measurement is most appropriate for the MTM portion of the portfolio. The following are general qualities of VaR: Provides a measurement technique to estimate risk of positions, financial assets, and transactions Intended to predict the potential future range in the MTM value of the forward portfolio, not future realized losses If tracked and compared over time, has value as a trending tool for the portfolio to analyze changes Can measure risk across different assets, markets, and tenor while accounting for hedges and rolling them up into a single number Flexible enough to incorporate both implied volatilities/correlations as well as historical information if necessary Assumes that the portfolio remains static over the holding period. Measures of risk are useful and necessary, even when imperfect, for all components of a company’s portfolio. The following calculation parameters are most easily verified and validated for liquid (MTM) transactions or portfolios, regardless of accounting method: VaR methodology Historic, parametric (variance/covariance), or Monte Carlo methodologies are all acceptable. Holding period 1 day to 10 days for trading activity varying time frame for assets Confidence interval 99% or 95% one-tailed or two-tailed approach 1 For more discussion of this metric, please refer to the extensive literature on the subject such as P. Jorian’s work on VaR (see References).
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