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Used as a measurement of market risk by several different types of financial institutions, a value of risk involves the maximum amount of loss that is anticipated to occur with a given investment opportunity. The value at risk is calculated using three basic components or parameters, all of which are considered to be solid economic indicators. Determining a value at risk is a common practice and is often used as part of the process of predicting the worst case scenario that is expected to occur with a given security within a specified period of time.
Three factors of parameters form the foundation for calculating the value at risk, or VAR. The first factor has to do with the time period that the financial institution is required to hold on to the security. Sometimes referred to as the time horizon, this factor helps to establish the time frame for the projection on performance. A time horizon may range from a single twenty-four hour period, a successive period of ten days, or up to one calendar year. The preferred time horizon will often depend on the type of financial institution that is employing the strategy. For example, lenders may choose to conduct a value at risk based on a one year period, as this will help the lender to determine the potential risk in extending credit to the investor.
A second factor in determining a value at risk is the confidence level. Essentially, the confidence level is the amount of time within the time horizon in which the security is not expected to reach and exceed the maximum loss. Relatively high confidence levels indicate that the volatility of the investment is somewhat limited and there is a reasonable expectation of stable growth. The confidence level will usually not directly address market trends, although this factor is accounted for in the overall process.
The third parameter or foundational factor for arriving at a value of risk has to do with settling on the unit of currency to be utilized in the calculation. This may seem like a relatively unimportant factor. However, the choice of currency is very important to understanding and projecting the performance of the security for the cited period. Volatilities, along with standard or anticipated deviations from the projection and expected and unexpected shortfalls are directly impacted by changes in the performance of a given currency on the open market. Thus, the use of a currency that is anticipated to be relatively stable for the duration of the time horizon is desirable.
The point of a value at risk goes back to the investment portfolio. Investing is a process that is anticipated to generate revenue far more often than creating a loss. By properly calculating a value at risk can help to result in lower portfolio losses, as well as aid in positioning the portfolio to realize a greater return.