Value at Risk (VaR): What it is, how it is calculated and how it is used in market risk management
At a glance:
• Value at Risk (VaR) is a sophisticated statistical tool employed by fund managers and portfolio management teams to estimate the maximum potential loss over a specified timeframe.
• As this is a highly technical and institutional tool, the purpose of this article is purely educational: to explain how it operates behind the scenes in the markets.
At Carregosa NextGen, we share our knowledge to help you understand financial reports and risk behaviour in a more mature and informed way.
In the world of financial markets, effective risk management is what distinguishes a sustainable strategy from the risk of permanent capital loss. When reading financial reports, macroeconomic analyses or investment fund prospectuses, you will frequently come across one technical term used as the benchmark for market risk: Value at Risk (VaR).
Although VaR is a complex mathematical tool primarily used by portfolio managers, quantitative analysts, risk managers and highly experienced investors, it is essential for any investor to understand the concept in order to enhance their financial literacy.
This article does not suggest that you should calculate VaR yourself before buying a share. Instead, we are offering you the opportunity to embark on an educational journey with Carregosa NextGen Academy, which will help you to understand how professionals use this metric behind the scenes to protect large portfolios.
Value at Risk: what does it mean?
In essence, Value at Risk (VaR) is a statistical estimate. It provides an answer to a very specific question that institutional managers ask every day: "What is the maximum loss that can be expected for this fund or portfolio over a given period, assuming normal market conditions and a given level of probability?”.
To grasp the concept without getting bogged down in complex mathematical equations, it’s helpful to look at how experts interpret it:
If an equity investment fund has a VaR of €1,000 with a 95% confidence level over a one-day horizon, the management team will be aware that:
• Statistically, there is a 95% probability that normal market fluctuations will not result in a loss of more than €1,000 during the day.
• Should severe market movements occur, there is a 5% chance that the actual loss incurred will exceed this threshold (the out-of-the-norm scenario).
Value at Risk vs. Conditional Value at Risk (CVaR)
While Value at Risk (VaR) is the most popular risk benchmark available on the market, it has a key structural limitation in that it does not reveal what happens within the 5% margin of error. This is where the concept of Conditional Value at Risk (CVaR) comes into play.
Understanding the difference between the two helps you develop a much more resilient and mature view of actual risk:
| Risk Metric | Value at Risk (VaR) | Conditional Value at Risk (CVaR) |
|---|---|---|
| Business Concept | It acts as a "line in the sand”. | It is also known as Expected Shortfall. |
| What does it define? | It sets the upper limit for the amount of losses that are likely to be experienced on most typical days. | Its focus is exclusively on what would happen if the VaR safety net failed. |
| What does it calculate? | It calculates the loss threshold for a given level of confidence (e.g. 95%). | It calculates the average loss in the worst-case market scenario (5% risk). |
| The warning it gives | "Under normal market conditions, your losses won’t exceed this amount.” | "In the event of an extreme market shock and the limit is exceeded, your average loss within the risk zone will be this amount.” |
How to calculate the Value at Risk
For purely educational purposes, it is important to understand the structure of the parametric formula that computers and trading systems process behind the scenes:
VaR = Z × s × vt × V
This model uses four market variables as inputs:
• V (value of the investment): the total amount of capital that the fund has exposed to the market.
• t (time horizon): the time period considered when monitoring risk (usually on a daily basis on trading desks).
• s (volatility): the standard deviation of historical prices. If the prices of the listed companies in a fund fluctuate significantly, the volatility is high and the VaR rises.
• Z (confidence level): the statistical coefficient of probability (e.g. 1.65 at a 95% confidence level).
A fund with a value of €10,000 (V), with a daily portfolio volatility (s) of 2% and a confidence level of 95% (Z = 1.65), will have a theoretical daily VaR of €330. The technical team knows that the statistical risk is capped at this threshold on normal trading days. These figures are for illustrative purposes only and do not represent any actual products, portfolios or returns.
NextGen Note: while there are alternative statistical methodologies, such as historical simulation and Monte Carlo probabilistic models, the parametric approach is widely valued for its operational simplicity. However, it does tend to underestimate losses in extreme scenarios due to its assumption of a normal return distribution.
Advantages and limitations of Value at Risk
No financial indicator is completely reliable. Although the VaR has clear communication advantages, there are some severe limitations to its implementation that you should be aware of:
Advantages of the VaR
• Ease of interpretation: unlike other purely abstract metrics, VaR translates risk directly into euros. Knowing the loss threshold that should not be exceeded under normal market conditions makes the potential impact of an investment more tangible.
• Universal Comparative Benchmark: the Value at Risk (VaR) enables you to compare the risk of completely different types of assets using the same monetary criteria. For example, you can use the VaR to assess the risk of an individual technology share against that of a bond fund.
• Optimisation of Risk Management: it is a vital tool for establishing the maximum permissible loss and managing the portfolio’s capital allocation.
Limitations of the VaR
• Vulnerability to extreme events: the VaR is based on stable and normal market scenarios. However, it is ineffective in predicting severe systemic crises, sudden liquidity crises or geopolitical shocks.
• Strict reliance on the past: as the calculation is based on historical volatility, any structural changes to a listed company’s business model, or to the real economy, can make past estimates obsolete.
• Failure to account for the magnitude of the worst-case scenario: the indicator warns that there is a 5% probability of losing more than the estimated amount. However, it provides no information on whether this additional loss will be slight or represent the total permanent loss of the invested capital.
What are the key takeaways for investors?
VaR is a highly complex mathematical tool primarily used by institutions. What, then, is the practical benefit of understanding this concept?
The answer to this question depends on your level of analytical maturity. Understanding how these metrics work enables you to interpret the risks outlined in fund prospectuses, and to recognise that volatility is a measurable factor, not an abstract bogeyman, that can be measured by professional teams.
For inexperienced investors, there are other, much more practical indicators that are easier to read and monitor on a day-to-day basis. These include a share’s historical volatility, maximum drawdown (which shows the largest fall the asset has ever experienced) and the Sharpe Ratio, which measures whether the return obtained justifies the risk taken.
Alternatives to Value at Risk: other relevant indicators
To make your risk analysis more robust and mitigate the limitations of VaR, you can supplement your analysis with other relevant indicators:
Expected Shortfall (ES)
Expected Shortfall, also known as "Conditional VaR” or "CVaR”, measures the average loss in the event of a worst-case scenario, i.e. when value at risk is exceeded. This indicator is particularly useful for evaluating extreme risks, and its importance in financial regulation is growing.
Maximum drawdown
The maximum drawdown is defined as the largest cumulative fall in the value of an investment over a given period. Unlike VaR, which is probabilistic, this indicator reflects actual, observed losses, making it useful for assessing strategy resilience.
Volatility
Volatility is a measure of the variation in an asset’s price over time. While it does not directly represent a loss, it is a key indicator of risk and forms the basis of many calculation models, including Value at Risk.
Sharpe Ratio
The Sharpe Ratio enables investors to assess the return on an investment relative to the risk taken. This indicator is particularly useful when it comes to comparing the efficiency of different investment strategies.
Stress testing
Stress testing involves simulating extreme scenarios, such as financial crises or economic shocks. This approach enables the behaviour of a portfolio to be evaluated in adverse situations, providing a valuable complement to analysis based on normal scenarios.
Develop a resilient strategy with Carregosa NextGen
At Carregosa NextGen, we believe that transparency and financial literacy are the cornerstones of sound, informed decision-making. That’s why we provide GoBulling Investors with real-time market data and integrated tools to help them keep track of their investments.
If you want to develop your technical skills further, explore new indicators and master financial literacy concepts, the financial literacy content on the Carregosa NextGen Academy is a good place to start.
Contact us to find out how to integrate effective risk management models and investment solutions that are perfectly aligned with your profile, objectives, and level of market experience.
Value at Risk: FAQs
We’ve answered some of the most frequently asked questions about Value at Risk below.
How is Value at Risk used in practice?
Value at Risk (VaR) is a method of quantifying the level of financial risk to which a portfolio is exposed in clear monetary terms. It does this by estimating the maximum potential loss over a given time horizon and probability.
Do I need to calculate VaR to manage my personal share portfolio?
No. VaR is a tool designed for institutional and professional investors, requiring advanced knowledge of statistics and integrated data systems. When it comes to personal investment management, metrics such as drawdown and historical volatility are much more accessible and useful.
In what situations do I come across VaR in everyday finance?
References to VaR can be found in investment fund management reports, disclosure documents for complex financial products and risk disclosures from major investment firms.
Mini risk glossary: master the terms
To strengthen your analytical skills, take note of these four key definitions that affect your portfolio management:
• Benchmark: a financial indicator or reference index used to evaluate the performance and risk of your investment portfolio by comparing it to a standard benchmark.
• Standard deviation: the statistical metric used to calculate volatility. It measures the extent to which an asset’s returns deviate from their historical average: the greater the standard deviation, the more unpredictable the price behaviour.
• Maximum drawdown: the biggest drop in value that has been measured over a certain period of time.
• Volatility: the frequency and intensity with which an asset’s price fluctuates over a given period of time. In the markets, volatility is a direct indicator of short-term risk.
Legal Disclaimer: This article is intended for informational and educational purposes only. It does not constitute an investment proposal or recommendation to buy, nor does it constitute personalised financial advice from Banco Carregosa. Investing in financial instruments carries structural and market risks, including volatility, that could result in a partial or total loss of the invested capital. Past performance does not guarantee or reliably indicate future returns. Before making any financial decisions, we recommend consulting an account manager to assess the suitability of a strategy for your investor profile.