Value At Risk Analysis

1 Introduction

We define Value at Risk (VaR) is a measure of market risk of an asset or a portfolio. Financial institutions across the world use VaR to estimate the impact of future market fluctuations on their portfolios. However, there is no hard and fast rule that only financial institutions can use VaR. It is because, VaR simply tells the risk exposure of an entity to market conditions. Thus, one could compute the VaR for an oil marketing company in terms of crude oil price risk.

There are two fundamental elements to any VaR computation.

The Basel Accord of 1996 and subsequent amendments thereof stipulate reporting of VaR at 99% level of confidence. In India, RBI, in compliance with Basel Accord, mandates banks to report VaR at 99% confidence

Bernstein (1922) and Markowitz (1999) have documented the history of VaR measures in the context of portfolio theory. A. Holton (2002) focused primarily upon the development of VaR measures in the context of capital adequacy computations.

1.1 A brief history of VaR

While the term “Value at Risk” was not popular prior to the 1990s, its genesis lies further back in time. The mathematics behind VaR was largely developed in the context of portfolio theory by Harry Markowitz and others, though their focus was different: formulating optimal portfolios for equity investors. In particular, the focus on market risks and the effects of the covariance in these risks are central to how VaR is computed.

The beginnings of portfolio theory as regards the portfolio construction was traced to Hardy (1923) and Hicks (1935) talked about the benefits of diversification. Leavens (1945) offered a quantitative case, which might be the first VaR measure of portfolio of 10 bonds over some horizon. During those days, Leavens did not unequivocally recognise VaR metric, but rather he mentioned the “spread between plausible loses and gain.” It looks that he thought of standard deviation of the portfolio market

However, there was no formalised method of how the measure was calculated. The most widely recognized approach followed is Markowitz. In the aftermath of numerous disastrous losses associated with the uses of derivatives and leverage between 1993 and 1995, culminating the failure of Barings, the British investment banks, as a result of unauthorized trading in Nikkei futures and options by Nick Leeson, a young trader in Singapore, firms were ready for more comprehensive risk