Value at Risk (VaR) is a summary, statistical measure of total normal market risk of loss (total value that can be lost) on a certain portfolio of financial instruments at a certain confidence level. It measures how large could be potential likely losses due to “normal” movements in the market. The technique is one of the most recent techniques and was developed at JP Morgan.
Value at Risk (VaR) results is structured as follows:
“with X% certainty, company will not lose more than $V in the next N days.”
Value at Risk (VaR) is a snapshot of a current risk level. The Value at Risk (VaR) is a floor for potential loss that can be incurred, not a ceiling. The potential loss can be VaR or higher. VaR is used to make sure that the company can handle potential losses. The potential losses cannot necessarily be prevented or, in some cases, potential losses should not necessarily be prevented due to risk/return relationship.
The results of Value at Risk (VaR) analysis are expressed as a single number $V (VaR number) which is determined based on two parameters namely X% which refers to confidence level and N days which refers to the time horizon. $V refers to the maximum potential loss which will occur with X% certainty over N days which is number of days in the risk period under consideration. For example, with 1% certainty over a 5 days period.
Value at risk limits can be established for specific asset categories such as foreign exchange or real estate. The limits can also be set for various levels within an enterprise such as business unit level and overall company level.