Value at Risk

• Value at risk (VAR) is the minimum amount by which the value of an investment portfolio
will fall over a given period of time at a given level of probability.
• Alternatively, it is defined as the maximum amount that it may lose at a given level of
confidence Level.

Example:
- Assume VAR is $100,000 at 5% probability, or that it is $100,000 at 95% confidence level.
- The first definition implies that there is a 5% chance that the loss will exceed $100,000, or
that we are 95% sure that it will not exceed $100,000.
- VAR can be defined at any level of probability or confidence, but the most common probability
levels are 1, 5 and 10%.
 Value at Risk
• In general the VAR will be given by:
VAR = kσ√N
Where - k is determined by the probability level,
- σ is the standard deviation and
- N is the periods over which we want to calculate the VAR.

Having defined the VAR, we can define the project value at risk (PVAR),
PVAR - As the loss that may occur at a given level of probability over the life of the project.
 Value at Risk
Example
The annual cash flows from a project are expected to follow the normal distribution with a mean
of $50,000 and standard deviation of $10,000. The project has a 10 year life. What is the PVAR
if probability is 5% ?
The PVAR for a year is:
PVAR = 1.645 x $10,000 = $16,450
The PVAR that takes into account the entire project life is:
PVAR = 1.645 x $10,000 x 10 = $52,019; this is the maximum amount by which the value of the
project will fall at a confidence level of 95%.
So far we have used the normal distribution to calculate the VAR. The assumption that project
cash flows or values follow the normal distribution may not be plausible.
 Value at Risk
ADVANTAGES
• It’s easy to understand
• Comparing VAR of different assets and
portfolios
• The VAR provides an indication of the
potential riskiness of a project
DISADVANTAGES
• Value At Risk can be misleading: false
sense of security
• VAR does not measure worst case loss
• The resulting VAR is only as good as the
inputs and assumptions
• Different Value At Risk methods lead to
different results
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