Value at Risk
Managing your risk in your trades and investments is one of the most important steps you need to keep in mind. For this purpose, you need to have measures to have a sense of your risk. Value at Risk is one of those measures. Read the rest of the article to find out what it is and how you can use it.
A Short Story
Imagine you are somehow optimistic about the value of the dollar against the Euro. Maybe you hope Elon Musk might tweet about it! You have decided to consider it a short position in Euro and a long one in the dollar. You want to invest a million in this and need more information to make sure you’re making the right choice. What if events do not turn as you predicted? What amount of loss should you prepare yourself? What is the worst thing that could happen?
The answer is you can’t know anything for sure, but you can estimate it based on historical data. The exchange rate behaviour in the past can give us a sense of how it will behave in the future. We can calculate the probability of the potential loss. There are different measures to do this, one of the most accurate and the coolest is VaR.
What Is It?
VaR or Value at Risk is the maximum amount of loss in an asset or portfolio that can happen in a specific time horizon and with a certain probability. In your case, a financial advisor may tell you that your daily VaR is 10K dollars a day with a confidence level of 95%. So You can be 95% sure in the worst-case scenario that your daily loss would amount to 10K dollars. In other words, in the worst-ever imaginable scenario, you lose 10K dollars every 20 days.
In his fascinating book on the risks and benefits of investment, Financial Risk Manager Handbook, Philippe Jorion gives a thorough reference for the FRM certificate. He emphasizes that the concept of VaR should be precisely understood. It does not tell us that losses of more than 10K are impossible. It says that a loss of more than 10,000 dollars can happen only once in 20 days. Moreover, It does not convey that your once-in-20-days loss will not be more than 10K dollars. That can be pretty large. The VaR measure assures you that you will experience those losses only 5% of the time.
Case in Point
According to a study available online, the VaR of Bitcoin was 42.43, and that of Ethereum was 45.97 over specific ten days starting from April 30 2018. You could have been 99% sure that your loss in those ten days would not exceed 42.43 dollars in Bitcoin and 45.97 dollars in Ethereum for every 100 dollars you invested in them. You can see how Ethereum is more dangerous!
Let’s Put It in Practice
- You have to be aware of the odds of losing money in your investments over different time horizons. VaR gives you this power. The daily VaR can calculate weekly, monthly, and annual VaR. For example:
This way, you can have a sense of the maximum loss you can expect to take during a particular time horizon.
- Always keep tracking the VaR of your portfolio as a measure of risk. When you feel it is too high, add some low-risk assets.
Bear in Mind
Keep in mind that VaR is a historical measure and might not predict the future very well. However, sometimes this is the best we can do to avoid a serious loss! Sometimes they might violate VaR, and the more they do that, the riskier they are. One research showed that Bitcoin violates more often than gold and SP500. Have you ever heard of black swans? They are not that rare in Bitcoin land.
