The purpose of this article is to gain a concrete understanding of the perception of Value at Risk, its strengths and weaknesses, and controversies related to its use in managing risk. Two articles will be used to help with the understanding of VaR, “An Irreverent Guide to Value at Risk,” by Barry Schachter and “Subjective Value-at-Risk,” by Glyn Hoyt. These articles will give us some background by describing VaR, understanding its limits, and its developing role in risk management.
Article 1 “An Irreverent Guide to Value at Risk”
Value at Risk has been called the “new science of risk management.” Around the world, organizations are sprinting to implement the new technology.
Because of its technical being, I would first like to give you 3 equal definitions of VaR given by the author.
1. A prediction of a given percentile, usually in the lower tail of the distribution of returns on a portfolio over some period; similar in principle to an estimate of the expected return on a portfolio, which is an estimate of the 50th percentile.
2. An estimate of the level of loss on a portfolio which is expected to be equaled or exceeded with a given, small probability.
3. A number invented by purveyors of panaceas for pecuniary peril intended to mislead senior management and regulators into a false confidence that market risk is adequately understood and controlled.
This is a statistical method used to calculate and specify the level of financial risk within a firm or investment portfolio over a limited time frame. The risk manager's task is to guarantee that risks are not taken beyond the level at which the firm can absorb the losses of a likely worst outcome. VaR is just a number created to give senior management false certa...
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...utcomes can further provide information on expected losses over a given time period. Stress testing is used as a supplement for VaR analysis. “Because VaR does not capture all relevant information about market risk, its best use is as a tool in the hands of a good risk manager.”
There is a reason to be skeptical of both its quality as a risk management instrument and its use in decision making.
Article 2 “Subjective Value-at-Risk”
Value-at-Risk is becoming extremely popular and is being bandied by pundits into measuring other risks such as credit and operational risk, and many believe that all risks of a company should be computed with a single risk measure. The author believes that if this were so there would be a lot of backlash due to VaR being controversial and that it still may be ineffective for analyzing these other risks as well as market risk.
The Group is exposed to a various financial risk which mainly includes liquidity risk, market risk, credit risk and cash flow risk. BDEV manages these risk by maintaining
The capital asset pricing model (CAPM) is a mathematical model that offers an explanation about the relationship between investment risk and return. By dividing the covariance of an asset's return by the variance of the market, an asset value can be determined. To ascertain the risk level of a particular asset, the market is evaluated as a whole. Unlike the DCF model, the time value of money is not considered. This model assumes the investors understands the risk involved and trades without cost. Two types of risk is associated with the CAPM model: unsystematic and systematic. Unsystematic risks are company-specific risk. For example, the value of an asset can increase or decrease by changes in upper management or bad publicity. To prevent total loss, the model suggests diversification. Systematic risk is due to general economic uncertainty. The marketplace compensates investors for taking systematic risk but not for taking specific risk. This is because specific risk can be diversified away. Systematic risk can be measured using beta. For example, suppose a stock has a beta of 0.8. The market has an expected annual return of 0.12 and the risk-free rate is .02 Then the stock has an expected one-year return of 0.10.
Obviously, financial establishments can endure breathtaking misfortunes notwithstanding when their risk management is top notch. They are, all things considered, in the matter of going out on a limb. At the point when risk management fails, be that as it may, it is in one of the many fundamental ways, almost every one of them exemplified in the present emergency. In some cases, the issue lies with the information or measures that risk directors depend on. At times it identifies with how they recognize and impart the risks an organization is presented to. Financial risk management is difficult to get right in the best of times.
...res risk sensitivity of the security to the market, and Alpha (α), which is the average, unexplained return (that is, return not explained by the market). (Weston et al, 2004).
No firm can be a success without some form of risk management. Risk are the uncertainty in investments requiring an assessment. Risk assessment is a structured and systematic procedure, which is dependent upon the correct identification of hazards and an appropriate assessment of risks arising from them, with a view to making inter-risk comparisons for purposes of their control and avoidance (Nikolić and Ružić-Dimitrijevi, 2009). ERM is a practice that firms implement to manage risks and provide opportunities. ERM is a framework of identifying, evaluating, responding, and monitoring risks that hinder a firm’s objectives. The following paper is a comparison and evaluation to recommended practices for risk manage using article “Risk Leverage
Risk management is a process used in all industries to reduce the risk. The Risk management tool usage changes from sector to sector and hence each sector has developed their own risk management tools and methodologies to mitigate the risk. But the concept remains the same behind all the tools (Ropel, 2011). The main steps for risk management irrespective of the sector are:
Of course Unsystematic risks are relevant on its own as they can harm many individual securities, firms or markets. Nevertheless, if one accepts the purpose and validity of portfolio diversification which is designed to remove Unsystematic risks, then it is unavoidable or Systematic risks that bear a real
The key purpose for managing risk is to evaluate the risk and improve the performances of consolidated value of a firm to achieve profitability. Currently the benchmark tool for measuring the risk is VAR (Value at Risk). VAR evaluate the maximum loss a value of a portfolio has for a given interval on a pre-determined period of time. It is commonly used in brokerage houses, investment banks and institutions to measure a risk on their portfolios.
This table was created with the help of a macro called Map2. Cash flow mapping is map the portfolio to a set of several risk factors by taking the future cash flow and discounting it by the sport rate. In other words, is a procedure for representing a financial instrument as a portfolio of zero-coupon bond for the purpose of calculating its value at risk. This portfolio accounts with three cash flows that have no risk associated in the periods .025, 0.05, and 1 year. The variance of this portfolio is calculated to be 9.37 and a risk of $968,247.29. The Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose, given normal market conditions, in a set time period such as a day. The 10 day 1% VaR for this portfolio is
Cost of capital refers to the cost of obtaining funds, that is, debt or equity to finance an investment project. The cost of capital is useful in assessing the applicability of a capital account because the cost of capital is the lowest return for the investor to fund the company. Different sources of capital have different capital costs. On the other hand, risk refers to the uncertainty that exists in making financial decisions. Because the forecast may be different from the actual result, for example, the stock price may change unfavorably. The risk can be divided into two categories: systemic risk and non-systemic risk. The risk is measured by variance analysis or beta. (Brigham & Ehrhardt, 2011).
...a measure of economic risk). When multiple risky assets are held within a portfolio, it can be expected that some properties will increase in value while at the same time others will decrease in value. By holding risky assets in groups, some of the risk of each asset may be reduced or eliminated through the process of diversification.
Commencing since the mid-1990s a measure of risk recognized as value-at-risk (VaR) has appeared as the prevalent risk measure for financiers in financial securities, banks and investment companies and the controlling powers that standardize these institutions. VaR is also an important part of both the Basel I and Basel II suggestions upon banking rules published by the Basel Committee on Banking Supervision. Security and Exchange Commission of Pakistan (SECP) also emphasized the significance of VaR measures for financial institutions to quantity the risk.
These types of uncertain circumstances arise when the individual does not know the precise trade-off, such as purchasing stocks and bonds. Key concepts used to mitigate risk are titled Expected Value, Variability, Risk Aversion, Certainty Equivalent and Risk Premium, and Risk Aversion and Compensation. The first concept, Expected Value, is defined as the weighted average of all the possible outcomes, where the probability of each outcome is used as the weights. The expected value is used to soften risk by measuring the average payoff that will occur. An example of this would be turning a paper with three questions on it. The concept of expected value is calculated by multiplying the probability of each outcome (1/4) by each possibility (0, 33, 66, and 100), then adding them all together, to find the average (50), or expected value. Once Expected Value is calculated, it is important to follow up with the next concept, Variability, because the expected value is not certain. Variance, meaning the measure of variability, can be found by multiplying the probability of each outcome (1/4) by the difference between each possible payoff and the expected value (0-50, 33-50, 66-50, and 100-50), squaring each individual calculation, then adding each calculation together (619). However, the
Ananth Madhavan and Jian Yang (2003), in their article titled, ‘Practical risk analysis for portfolio managers and traders’. This article provides a detailed overview of recent development in risk analysis and modeling with a focus on practical application for both portfolio managers and traders.
As has been discussed before, risk identification plays an important part in the risk such as unique, subjective, complex and uncertainly. There are no two identical leaves in the world; similar, there are no two exactly the same risk either. Hence the best risk manger could not identify risk completely. Besides, risk identification assessment is done by risk analysts. As the different level of risk management knowledge, practical experience and other aspects between individuals, the result of risk identification may be difference. Furthermore, the process of identifying risk is still risky. Once risks have been identified, corporations have to take actions on limiting risky actions to reduce the frequency and severity of risky. They have to think about any lost profit from limiting distribution of risky action. So reducing risk identification risk is one of assessments in the risk