The following are some of the advantages and limitations of the VaR.
- Easy to understand: VaR is a single number that approximates the amount of risk in a portfolio. VaR is presented either as a percentage of the value of a portfolio or simply in price units such as dollars. This makes it easy to understand and interpret.
- Applicability: VaR can be used to measure and make a comparison of risks across asset classes and portfolios. This equips the risk manager with relevant information on possible risks.
- Acceptability: The VaR figure is a widely accepted standard in the buying or selling of assets. Besides, it is acceptable to banking regulators. VaR has the same interpretation irrespective of the assets you are considering. Further, VaR is regularly seen in annual reports of financial companies.
- Used for performance evaluation: Instead of evaluating a firm’s performance purely based on returns, a risk-adjusted return can be calculated by considering the level of risk taken. In this case, VaR can serve as an adjustment basis.
- Reliability: VaR, as a measure of risk, can be verified by backtesting.
- Depends on inputs and assumptions: The parametric method, for instance, assumes that asset and portfolio returns follow a normal distribution. Consequently, one might end up using unrealistic return distributions as inputs. In turn, this will lead to underestimation of the real risk. Furthermore, the assumption by the historical simulation method that the past performance of a portfolio is a good indicator of its performance in the near future is unrealistic.
- Inconsistent results: Different approaches to calculating VaR use varying assumptions and, as a result, end up getting different values of VaR of the same portfolio.
- Misleading and a false sense of security: When VaR is calculated at a confidence interval of 99%, then its interpretation is that there is a 99% probability that one will lose no more than the VaR value obtained. This may give an investor a false sense of security.
- Difficult to calculate given large portfolios: Having many diverse assets complicates the calculation of VaR. This is mainly because to obtain VaR, the correlation between the assets, as well as the risk and return of all the assets, must be calculated.
- Subjectivity: Calculating the VaR involves choosing parameter estimates, distribution assumptions, percentage of loss, as well as the lookback period. These choices can immensely affect the VaR.
Which of the following is an advantage of VaR?
- VaR can be used to measure and compare risk across different asset classes.
- VaR is a limited acceptable measure of risk.
- VaR measures downside risk.
The correct answer is A.
VaR allows the comparison of risk across different asset classes and portfolios. Therefore, an investor is better informed since they have a better picture of the assets and portfolios contributing the least and most risk.
B is incorrect. Financial firms widely use VaR for financial reporting. Moreover, regulators encourage the use of VaR as a measure of risk. However, they neither impose a maximum VaR nor prescribe methods of estimating VaR.
C is incorrect. VaR focuses mainly on the downside risk and heavy losses (left tails), disregarding right tail events (potential gains). To have a better understanding of the risk-return tradeoff, we need to examine both tails of the distribution.
Reading 42: Measuring and Managing Market Risk
LOS 42 (d) Describe the advantages and limitations of VaR.