VaR: Value at Risk

Q: How VaR different from credit risk?

A: While the credit risk is associated with the probability of default by a counterparty in a derivatives contract. The VaR is about changes in the market variables to which any FI is exposed. It's a single number summarising the total risk to a portfolio of financial assets. Moreover, Central bankers also use this number to arrive at the capital required by the bank to reflect the risk its bearing. Specifically, VaR calculation is aimed at making a statement of the form: "We are X % certain that we are not going to lose more than $ V in the next N days."

Q: How is VaR calculated?

A: There are two ways of calculating VaR: The Historical Simulation approach and model building approach. The first approach uses past data to arrive at The joint probability distribution of market variables. But it is computationally slow and doesn't incorporate volatility updating schemes. The second approach is faster and can be used in conjunction with volatility updating schemes. But it assumes that market variables follow multivariate normal distribution, which may not be the case in practice.