This lesson covers the quantitative techniques used to measure financial risk, with a focus on Value at Risk (VaR).

7.1. Value at Risk (VaR) Fundamentals

VaR is a standard measure for quantifying market risk. It estimates the maximum potential loss of a portfolio over a specific time horizon at a given confidence level. VaR is used to set risk limits and allocate capital.

7.2. VaR Methodologies

There are three primary methods for calculating VaR:

  • Variance-Covariance: This method assumes that asset returns follow a normal distribution. A key limitation is that “it does not support optionality,” making it less suitable for portfolios containing options .

  • Historical Simulation: This method uses actual historical returns to simulate possible future outcomes.

  • Monte Carlo Simulation: This method generates thousands of random possible future scenarios for market prices.

7.3. Key Risk Metrics

Other key risk metrics include:

  • Standard Deviation: A measure of total risk for an individual security.

  • Correlation: A measure of how two securities move in relation to each other, which is essential for portfolio diversification.

  • Z-Score: A statistical measure that indicates how many standard deviations an element is from the mean .

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