4 minute read
Value at Risk (VaR) is a common statistical method for quantifying risk. It's used extensively in the investment management community and by large corporates, but for SMEs and smaller firms managing their currency risk, it's scarcely used.
Oku Markets uses VaR as a key risk quantification metric however, it's important to be clear with the parameters and never to use it standalone!
What is Value at Risk?
VaR attempts to quantify the maximum loss that can occur with a degree of confidence and over a specified time period. For example, a portfolio with a 1-week VaR of £1m at 95% confidence means that in 95 out of 100 weeks, the maximum loss will not exceed £1m.
We can think of VaR as the likely worst-case outcome, although we must be mindful of the limitations of the metric and precisely what "likely" means in reality. Value at Risk won't reveal what could happen in a catastrophic blow-up event.Harry Mills, CEO & Founder Oku Markets
💡 It's a good idea to consider your VaR in terms of your risk appetite and your maximum acceptable loss limits
When calculating VaR there are three main approaches:
- Historic: using real historic data as the basis for the view of the future
- Parametric: assumes that returns are normally distributed
- Monte Carlo: randomly generating many thousands of scenarios as the input
We recommend to use VaR alongside stress-testing, scenario analysis, and other measures of risk for the underlying currency pairs you deal in.
Advantages of VaR:
- Provides a statistical probability of potential loss
- Can be readily understood by non-risk managers
- It's universal and can be applied to many financial portfolio types
Disadvantages of VaR:
- Like any model, if the inputs are found to be untrue, the output won't be reliable
- The different calculation methods can produce different VaR figures
- VaR gives no indication of how large losses could be (beyond the confidence level)
The third disadvantage listed above is critical, and explains why its important not to exclusively rely on VaR as your risk measure. It fails to capture the size of losses associated with the "tail" of the probability distribution! Using the example from earlier, losing up to £1m on 95 days out of 100 says nothing about the other five days other than the potential loss is greater than £1m!
Should I use VaR for my business?
If you think it's useful to plan ahead and know your potential risks, then you should probably know your VaR. Without an idea of potential losses – the size of your downside risk – it will be difficult to know whether your level of risk is within your acceptable limits or not.
Used in conjunction with other risk measures, VaR is a practical and clear metric that helps to articulate currency risk into terms that make sense to non-risk managers: losses in pounds and pence!
👋 Contact Oku Markets to build your business currency risk report by writing to us at [email protected] or calling 0203 838 0250