Definition
VaR answers the question: "What is the worst loss expected under normal conditions over a given period?" For example, 1-day 95% VaR of $1M means there is a 5% chance of losing more than $1M in a single day. VaR is the most widely used risk measure in banking and is required for regulatory capital calculations under Basel accords.
functions Formula
VaR = Portfolio Value × z-score × σ × √t
lightbulb Example
A $10M portfolio with 2% daily volatility. 1-day 95% VaR = $10M × 1.645 × 2% = $329K. There is a 5% chance of losing more than $329K in one day.
Warning
VaR does not tell you how bad losses can get beyond the VaR level. CVaR (Expected Shortfall) addresses this limitation.
verified_user Key Points
- Widely used in banking and regulation
- Does not measure loss magnitude beyond VaR level
- Common confidence levels: 95% and 99%
- Three methods: parametric, historical, Monte Carlo