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Advantages of VaR
- Consistent: easy to use across diff LOB & products
- Probability based: can specify confidence level
- Common time horizon
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Calculation of VaR
- 2-step process: (1) generate prob dist for price or return of each security, and (2) aggregate the individual distributions using an appropriate assumption about their correlation
- Usually assumes PF composition doesn't change, which is fine as long as time horizon does not exceed 5 days
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Uses of VaR
- Risk reporting
- Risk control
- Risk mgmt
- Capital allocation
- Exposure monitoring
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4 derivatives disasters
- Proctor & Gamble: fixed-for-floating interest rate swap w/ spread heavily reliant on no rate incr. VaR was of no help since not intended for transactions
- Barings: bet on japanses stock mkt. Mgmgt wouldn't have been able to monitor VaR as the trader was responsible for recording his own trades
- Orange County: VaR wouldn't have make a change if potential updside was considered too
- Metallgesellschaft: sold fixed-price oil contracts and hedged risk using short term future contracts. They had full knowledge of risk (were using selective hedging)
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Alternatives to VaR
- Cash Flow risk: simulation
- Risk based capital: evaluate opportunities
- Shortfall risks: focus on shortfall relative to some doomsday level
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