Marginal, Incremental and Component Value at Risk (VAR)
In the previous articles, we have studied how the value at risk (VaR) models should be used to calculate risks. However, the calculation of risks is not the ultimate end goal. Instead, it is efficient management of this risk that makes the value at risk (VaR) model valuable.
Lets assume that in a particular instance, the value at risk (VaR) model gives a value that is unacceptable to the organization. In such a situation, the organization would ideally have to divest a part of its portfolio in order to reduce the overall risk. Here it will be faced with the question about which part of their portfolio should be divested. Hence, the risk characteristics of sub-portfolios present within the portfolio will have to be measured in order to decide which part should be divested.
Such calculations are done using marginal, incremental, and component value at risk (VaR) models. These models allow the overall risk to be broken into its component parts for the purpose of analysis.
In other words, these models are used to drill down the overall value at risk (VaR) number into its constituent parts. In this article, we will have a closer look at what these statistics are and how they should be interpreted.
Define sub-portfolio: The first step in conducting and kind of drill-down analysis is to clearly define component parts. These component parts are then labeled as sub-portfolios and all the statistical analysis is done at a sub-portfolio level. Different organizations define their sub-portfolios in different ways.
Some organizations define their sub-portfolios at an asset class level. This means that the stocks will be considered to be one sub-portfolio, whereas bonds will be considered another one and derivatives will be considered a third one.
Similarly, it is also possible to define a sub-portfolio at the line of business level. For instance, corporate banking can be considered to be one sub-portfolio, investment banking can be considered to be a second portfolio whereas retail banking can be considered to be the third one.
Once the component parts have been decided, the next step is to break the overall value at risk (VaR) into these components.
The bottom line is that marginal, component, as well as incremental value at risk (VaR), provide market risk managers with an important tool for understanding the root cause of the market risk. This helps risk managers identify the sub-portfolios which are creating disproportionately high risks and then eliminate them.
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