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Risk Measurement

In: Business and Management

Submitted By lylishermiyati
Words 324
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VAR is one of the simple and widely used risk measures that attempt to summarise the total risk of the portfolio. Despite of its popularity within Financial Intuitions, Treasures and Fund Managers, there are frequent criticisms against its use which we will discuss in this part.

One of the criticisms is that VAR focuses on the risks around the middle area of the distribution and completely ignores the tail portion which is associated with large losses. (Glasserman, Heidelberger & Shahabuddin, 2002, P239). So, the probability of the portfolio losing side has not been evaluated enough. For example, the interpretation of VAR number $904,617 calculated previously for the bank’s portfolio is that there is a 99% probability that the maximum loss will not exceed $904,617. This may not be the case if the 1% loss is of significant amount and of unpredictable nature. Measuring rare events such as Bank Robberies and Natural disasters are almost impossible. The use of historical data in such context is not sufficient enough predict the future which can lead to excessive risk taking or not hedging property. It may turn out to be like an airbag in a car that works all other times but the time of an accident.

Another criticism is regarding the Subadditivety. The sum of VAR of two portfolios is actually larger than the sum of 2 VARs. The end result should be either equal or lesser than the sum because diversification actually reduces the risk. This violates diversification principle and it exists because VAR is not an actual loss amount but a quantile on the distribution of profit and loss. Accepting sum of VAR as a maximum loss amount can create a false sense of security for Senior Management and executives. A study by Danielsson & Jorgension 2005 found that VAR is normally subadditive for all fat tailed distributions except for distributions with super fat tails. Some examples of super fat tails are Options...

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