All you need to know about VaR!

Value at Risk (VaR) is a popular risk measure used by fund managers.

In the world of finance, the risk is at the stem of the whole system. Understanding the risk-return mechanism is the most crucial part of understanding and managing investment for all investors. Lately, you might be aware of the broker or mutual funds ads that show up on various media, but did you ever notice what does it say in the end? It provides a safe harbour statement saying, ‘investments are subject to market risk’.

Market risk is something that cannot be eliminated. It is the risk arising from changes in the market dynamics, to which a particular organization or fund has exposure. 

Let’s suppose we are managing an ETF that tracks the Nifty 50 index. Then what are the market risk exposures we are looking at? Aggregate demand in the economy, interest rates, regulatory changes, and many other risk exposures. Risk management involves identifying such risk exposures and estimating their impact on the portfolio. VaR is one such tool that has emerged as one of the most important risk measures. 

Definition and interpretation: 

Value at Risk is the minimum loss that would be expected in a certain percentage of the time and over a certain period given the assumed market conditions. Let’s understand it with a simple example. Suppose a fund value is at Rs 100 crore and a 5 per cent monthly VaR is 2 per cent. This means that there is a 5 per cent chance that the fund may lose a value of a minimum of Rs 2 crore in a month. However, it is crucial to note that the VaR doesn’t tell us the maximum loss that can be incurred in a month. The maximum loss can be Rs 100 crore in this case. 

To put it in a nutshell, no risk model can accurately predict the losses due to market risks. However, one can make estimates about the losses, for which VaR can be a helpful measure.