Value at Risk (VaR)

Overview

VaR estimates the maximum loss a portfolio can suffer over a given time horizon at a specified confidence level. Example: "95% 1-day VaR of $1M" means there's a 5% chance of losing more than $1M in one day. Three methods: parametric (normal), historical simulation, Monte Carlo.

When to Use

Trigger conditions:

• Quantifying portfolio downside risk for risk management
• Setting trading limits and capital reserves
• Regulatory reporting (Basel III requires VaR-based capital)

When NOT to use:

• When you need to know how bad losses CAN get beyond VaR (use CVaR/Expected Shortfall)
• For illiquid assets with no price history (VaR needs return data)

Algorithm