Value at Risk

1. VaR represents maximum potential loss in value of a portfolio of financial

instruments with a given probability over a certain time horizon.

2. VaR for a portfolio has similar concept as standard deviation for a portfolio has:

3. VaR can be measured with two methods: (i) Linear Valuation Method: a) Delta
Normal Method (ii) Full Revaluation Method (a) Historical Simulation (b) Monte Carlo
Simulation

4. Linear Valuation doesnt work for portfolios of non-linear securities

5. There are two explanations for the Fat Tails: (i) Conditional Mean: Mean changing
over the period of time (ii) Conditional Volatility: Volatility changing over the period of
time

6. Implied Volatility: It is forward looking, predictive. It is the value for such that
Black & Scholes price is equal to the observedmarket price

7. Full Revaluation Method accounts for non-linearity of derivatives whereas delta

normal assumes a linear approximation. It is also important to understand that it
accounts for extreme fluctuations

8. You can expect at least 1 question on Historical Simulation. It has a benefit that
there are no assumptions required about the distribution of returns. It is not exposed
to any model risk. The biggest drawback with the Historical Simulation method is that
the changes in volatility and correlation from structural changes are not recognized

9. The Monte Carlo approach assumes that there is a known probability distribution
for the
risk factors

10. The best methods depend on speed required and whether the portfolio has non-
linear elements

11. One shall understand that: Some companies define operational risk as all the risk
that is not market or credit risk. But this is a very broad definition of operational risk.
The Basel definition of operational risk is the risk of direct or indirect loss resulting
from inadequate or failed internal processes, people and systems or from external
events

12. One should remember that there are two kinds of rating: (i) Internal Rating (ii)
External Rating

13. Transfer risk is the risk that the government will impose restrictions on the
transfer of funds by debtors in the country in question to foreign creditors, either for
financial or other reasons. This risk is almost exclusively related to foreign currency
exposure

14. It is important to understand Expected Loss: EL = Exposure * LGD*PD. EL is the

amount the bank can lose on an average over a period of time

15. Banks need to create a loan loss reserve based on historical data for the losses
which they expect. Expected Loss (EL) is based on certain values of UGD, LGD, PD
which are calculated. The Banks need to be prepared with some capital if the EL
varies from the average historical behavior. This deviation from the average EL is
known as Unexpected Loss (UL)

16. The required capital reserve which acts as a buffer against insolvency for the
bank in the event of the default by an obligor is known as economic capital.

We hope that this tutorial must have given you good insights into 'Value at Risk
(VaR)'.