VaR Primer with Excel Modeling
Peter ONeill, Thomas Egan and Leslie McNew
Peter ONeill is currently chief risk
officer and head of finance for Uniper
Global Commodities North America. He
has been involved in energy markets
and risk management for almost twenty
years, having worked and held roles for
various multinational energy firms.
Thomas Egan is currently the senior
portfolio manager with Trust Company
of Illinois. He has over 30years of
financial analysis and portfolio
management experience, including
positions with Big Four accounting
firms and Fortune 500 companies.
Leslie McNew is currently the
managing director of N3Q, MMspire
Trading Company and executive
in residence of the Kania School of
Management, University of Scranton.
She has thirty years of experience in
physical and financial markets and has
held senior risk management roles at
five Fortune 500 companies.
Abstract: Despite the use of the value-at-risk (VaR) methodol-
ogy being widespread in finance, many individuals are not
offered the opportunity to understand the methodologies
of the various basic VaR models, the model limitations,
and how to produce a quick VaR model in Excel. This
brief covers a fundamental overview of risk theory, the
three most presented VaR model methodologies, historic
and parametric VaR equations, and using VaR to help set
risk limits and to setallocation of risk capital. The final
portion of the brief is devoted to building both the one-
factor historic VaR model and the two-factor parametric
VaR model in Excel. This brief is experiential in nature,
allowing the participant to gain a firm understanding of
VaR, the methodologies and limitation of different VaR
models, and how to produce basic VaR models in Excel.
Keywords: Abraham de Moivre, bell-shaped curve, Bernoulli,
Bloomberg, chance, confidence interval, correlation,
deterministic, distribution, dollar amount loss, DOW,
Excel, Gerolamo Cardano, GIGO (garbage in, garbage
out), Harry Markowitz, histogram, historical VaR, illiquid,
kurtosis, leptokurtic, Monte Carlo, non-normal return,
normal distribution, parametric VaR, path-dependent
pay-offs, portfolio, probability, probability, randomness,
Risk, risk capital allocation, risk limits, skew, skew, stan-
dard deviation, stress testing, Thomas Bayes, time period,
transparency, Value at Risk (VaR), VaR limits, volatility,
Executive Summary
Many students enter the workplace with only the ba-
sic knowledge of financial risk, such as Value at Risk
(VaR), which summarizes the expected maximum loss
(or worst case loss) over a target horizon within a single
summary statistic (confidence interval, or standard de-
viation). They will state in an interview something like:
I am 95percent confident that this position (portfolio)
will lose no more than $760 K in one day. What they
sometimes struggle with is:
the differences in VaR models and how the differences
impact the dollar value of risk;
how VaR horizon periods impact the dollar value of risk;
Expert Insights 1
 VaR Primer with Excel Modeling
the properties of a normal curve and what
does risk look like when the data curve
is not-normal;
how to build a basic VaR model in Excel
to use it to check their business models
(both historical and parametric); and
how to do a back of the envelope VaR /open-knowledge/topics/finance/articles
assessment to illustrate risk on the fly:
like assessing the risk of a new struc-
tured deal and its risk level on the overall
investment book.
This brief is divided into three parts.
Part1 is a simplistic overview of the history
of quantifiable risk. Part 2 reviews the three
types of VaR models and simply addresses
how to use VaR. Part 3 is an experiential
Excel discussion on building a historical
VaR model and a two-factor parametric VaR
model.
Part 1: Simplistic Background on the
History of Quantifiable Risk
The word risk comes from the old Italian
risicare, which translates to to dare. Risk
is not fate; it is an option. Fate meant that
no matter what one did, the gods decided
the outcome. The revolutionary idea that
defines the boundary between modern
times and the past is the mastery of risk:
the notion that the future is more than a
whim of the gods and that men and women
are not passive before nature. 1 Accepting
that risk is not fate meant that we can work
to mitigate any outcome, that our future
outcome could be in our hands.
The roots of quantifiable risk come
from the medieval period around 1450
when Gerolamo Cardano, an Italian law-
yer, physician and friend to Leonardo
da Vinci, liked to gamble. In order to try
and maximize his winnings, he began to
investigate the basic concept of probabil-
ity when throwing dice. His work would
prove important just over a century later,
in the mid-1660s, when Blaise Pascal and
Pierre de Fermat defined a method for
calculating probabilities that enabled fore-
casting, with gambling once again the
2 Expert Insights
driving force. While in games of chance
the outcome of an individual trial cannot
be predicted with certainty, the mathema-
ticians said, collective results over a long
period of time display a certain regularity.
(https://www.allianz.com/en/about_us
/150723-principles-of-risk/).
As time progressed into the 18th century,
Abraham de Moivre discovered the nor-
mal curve of distribution (the bell curve),
which gave the risk science the concept of
standard deviation. The bell-shaped curve
illustrated how likely it is that a random
process (the key here is the normal distri-
bution) becomes a particular value on the
x-axis. Values near the peak of the curve
are the more likely outcome. Values near
the edge of the curve, the tail, are less
likely. See Chart 1.
Chart 1
Source: http://www.intmath.com/counting
-probability/14-normal-probability
-distribution.php
Standard deviation provides a view of
clusters of data and how far individual
points are away from the mean (the mean
being the highest part of the normal curve).
A tight standard deviation states that the
data is clustered around the mean of the
curve; a wide or bigger standard deviation
states that the curve is not as peaked and
has a much flatter, rounded top with values
less likely to be tightly clustered around
the mean.
Every normal curve follows certain
probabilities, and these probabilities allow
us shortcuts to illustrating data and the
 VaR Primer with Excel Modeling
likelihood of that data occurring, as can be
seen in Chart 2:
Chart 2
Source: http://www.intmath.com/counting
-probability/14-normal-probability-distribution.php
its shape is symmetric (that is, when you
cut it in half the two pieces are mirror im-
ages of each other);
its distribution has a bump in the middle,
with tails going down and out to the left
and right;
the mean and the median are the same
and lie directly in the middle of the dis-
tribution (due to symmetry);
its standard deviation measures the
distance on the distribution from the
mean to the inflection point (the place
where the curve changes from an
upside-down-bowl shape to a right-
side-up-bowl shape); and
because of its unique bell shape, probabili-
ties for the normal distribution follow the
Empirical Rule, which says the following:
About 68 percent of its values lie within
one standard deviation of the mean. To
find this range, take the value of the
standard deviation, then find the mean
plus this amount, and the mean minus
this amount;
About 95 percent of its values lie within
two standard deviations of the mean.
(Here you take two times the standard
Expert Insights
deviation, then add it to and subtract
it from the mean); and
Almost all of its values (about 99.7 per-
cent of them) lie within three standard
deviations of the mean. (Take three
times the standard deviation and add
it to and subtract it from the mean).
Not long after de Moivres discoveries,
Daniel Bernoulli demonstrated that most
people are risk adverse and concerned
with only downside risk. Thus, given the
normal curve above, Bernoulli stated that
risk aversion meant that people are only
concerned with the left side of the nor-
mal curve. Bernoullis work was ground-
breaking in that he also considered an
individuals motivation when risk was
involved. His emphasis was on decision-
making, rather than on the mathematical
intricacies of probability theory . . . Risk
is no longer something to be faced; risk
has become a set of opportunities open to
choice.2
Other mathematicians built upon Ber-
noullis work throughout the 18th and 19th
centuries and expanded on theories related
to risk. Thomas Bayes crafted the Bayes
theorem, which dealt with probabilities
and knowledge of circumstances related
to an event; Carl Gauss delved deeper into
normal distribution curves; and Francis
Galtons work produced the concept of re-
version to the mean.
However, not all thinking about risk was
derived solely from mathematicians nor
was all their work accepted as accurate.
One of the worlds most famous econo-
mists, John Maynard Keynes, did not agree
with the quantifiable results of many of
the leading mathematical minds: Percep-
tion of probability, weight, and risk are all
highly dependent on judgment.3 Keynes
contemporary, University of Chicago econ-
omist Frank Knight, also questioned the
alleged certainty of many of the mathemat-
ical models and assumptions viewed at the
time with esteem. And they both despised
the mean statistical view of life.4
3