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An introduction to risk management

2.4 Value at Risk (VaR)

VaR is a measure of how much the value of an investment is likely to
decrease over a certain period of time, under a given ‘confidence level’.
It is measured using normal distribution theory.

Calculating VaR

1 Find the mean value and the standard deviation of the investment, and
set the ‘confidence level’ (usually 95% or 99%) (all will be given in the
exam).

2 Subtract 50% from the given confidence level, to leave a number (say
X) between 0 and 0.5.

3 Find this value (X) within the normal distribution table, and read off
(from the edge of the table) the corresponding value (say Y).

4 Multiply Y by the (given) standard deviation, then subtract the total from
the (given) mean.

5 The result is the value of the investment that we can be 95% or 99%
confident of achieving (whichever confidence level was used in step 1).

Illustrations and further practice

Now try Illustration 2 and TYU 2 from Chapter 9

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