Tuesday, July 28, 2009

VaR...not as hard as one might think

This past week I spent a day dealing with the single topic of Value at Risk (VaR). This was in a class I'm taking in my doctoral program. Our professor, Aron Gottesman, did a fantastic job showing how VaR isn't nearly has challenging as one might think. As a result, we will be holding a webinar dedicated to the topic and will also have this as a topic at our upcoming PMAR VIII.

Just about everyone in the industry has heard of VaR, but not everyone understands much about it. Concepts first: it reports the most money that can be lost, for a specific time period, at a specified confidence level. For example, the most your portfolio can lose over the next ten days is $100,000, at a 98% confidence level.

At PMAR VI I debated Robert Mackay on this topic, arguing that VaR is "voodoo," while he took the position that it has value. While I lost the debate, I still question the accuracy of the results given the way VaR works. Robert returned this year to PMAR VII and acknowledged that the results, as predicted last fall, were somewhat optimistic, given the significant downturn we saw. That's the challenge with VaR: it bases its predictions on past performance, which can often be met with a shock. And while these "one in a thousand year" events don't happen all the time, they clearly occur a lot more often than once every thousand years.

When using VaR, one must be careful as to how much credibility they place in the results. I'd argue that one thing we know is true: that the results are in error because of the faulty assumptions. However, they do provide valuable information. The recipient should understand what the assumptions were in providing the information and recognize that it's an estimate that may under or overstate reality.

If VaR is important or of interest to you, please join us when we hold our VaR webinar. And, consider joining us for PMAR VIII, when we'll go into a bit more detail on the topic. The webinar date will be announced soon.

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