What Is Value at Risk (VaR)?
Value at Risk is a single number summarizing portfolio risk: 'with 95% confidence, our loss over the next day won't exceed $X.' The standard is 1-day or 10-day horizons at 95% or 99% confidence levels. A daily VaR-99 of $100k means there's a 1% chance of losing more than $100k on any given day.
Three common calculation methods: historical (replay actual history), parametric (assume normal distribution and use volatility estimates), and Monte Carlo (simulate thousands of scenarios). All three suffer from the same problem: they assume the future resembles the past, which fails precisely during the events VaR is meant to warn about.
VaR is required by Basel banking regulations and widely used in institutional risk management. For retail traders, VaR is overkill — simpler measures like max drawdown and worst-historical-day capture similar information without the math. The famous critique of VaR ('VaR misses the tail risk') drove the financial crisis losses of 2008.
Related terms
- Maximum Drawdown — The largest peak-to-trough decline in account value or strategy returns.
- Sharpe Ratio — Risk-adjusted return — the excess return per unit of volatility.
- Risk Management — The systematic process of identifying and controlling exposure to losses.
- Volatility — A statistical measure of how much an asset's price varies over a period.