Value at Risk (VaR) is the most prominently used methodology when it comes to gauging and mitigating the market risk. Over the years, this methodology has been extensively used by financial as well as non-financial organizations. It has also been extensively used and recommended by academicians and researchers. The immense popularity of the value at risk (VaR) model can be attributed to some distinct advantages this model provides over other competing models. In this article, we will have a look at some of these advantages.
- Single Number: The value at risk (VaR) model condenses the risk management profile of an entire organization into a single number! This feature is very useful since it removes a lot of the complexity which is generally associated with market risk management. Before the value at risk (VaR) approach was invented, it was common for companies to calculate the risk of investments at an individual level.
However, we now know that the sum of individual risks does not always equal the portfolio risk. This is because some correlations also have to be accounted for while coming up with the portfolio risk. Since value at risk (VaR) is only a single number, it is quite easy to communicate this with different people in the organization. It is also easy to automate the risk management system.
- Ease of Interpretation: The value at risk (VaR) is also fairly easy to interpret. It simply means that most of the time, the value of loss will be contained within the range provided by the value at risk (VaR) number. However, in a small number of cases, the losses will exceed the upper limit mentioned in the range. This refers to the black swan or unexpected events which are difficult to plan for.
The management can then decide whether or not they are willing to take the maximum loss mentioned by the value at risk (VaR) model. If not, they can take measures to offload some of their investments and hence reduce their market risk.
- Comparable: Another benefit of using the value at risk (VaR) number is that this number is comparable with other organizations in the marketplace. Comparing two portfolios can be quite complicated and tricky. This is because the composition of the two portfolios may be very different from one another.
Hence, comparing their risk levels using traditional methods will be difficult. This is where the value at risk (VaR) model is very helpful. Organizations can easily compare their risks with other organizations even though they may be engaged in a completely different line of business.
- Network Externalities: Network externalities is an economic concept. In simple words, it means that if a product or service already has many users, it tends to get even more users. Hence, a lot of organizations are using the value at risk (VaR) model since other organizations are using it.
Also, the fact that value at risk (VaR) is recommended by Basel and other international regulators also adds to the list of reasons why it is widely used. Hence, if an organization tries to use a different risk assessment and mitigation model, it will be difficult since all its peers are already using the value at risk (VaR) model.
- Easy to Calculate: Also, value at risk (VaR) is relatively easy to calculate. The formula to calculate VaR is quite simple and straightforward. Also, most risk management software in the world already comes with built-in features which enable calculation as well as periodic monitoring of value at risk (VaR). This metric can also be calculated for different time periods. This allows conversions of value at risk (VaR) to different time periods which can then facilitate comparisons with other organizations.
The end result is that organizations do not need highly trained statisticians to help them calculate VaR. Instead, regular employees working at the firm can be trained to calculate the number with the help of advanced software.
- Regulatory Reasons: The regulatory bodies are another major reason why value at risk (VaR) is used by organizations all across the world.
Many regulatory bodies have made it mandatory for banks to create a VaR model and then allocate risk capital based on the results of this model. This can be thought of as being an endorsement of the validity of the model. The endorsement of industry-leading supranational organizations has definitely lead to increment in the popularity of this model
- Accuracy: Over the past few years, the value at risk (VaR) model has been extensively tested for accuracy. Organizations following this model have been able to accurately foresee the risks they face and have taken measures to avoid the risks. Hence, one of the main reasons behind the popularity of the Value at Risk (VaR) model is that it works.
The bottom line is that value at risk(VaR) is a tried, tested, and effective method to gauge and mitigate market risk. It has been used for many years because of the many advantages that it provides.
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