For the last 20-plus years, the term “VaR” has been used fairly frequently at big banks across the world. That’s because banks have been using VaR (value at risk) as a statistical tool to proactively manage risk for their clients for decades.
Fast forward to 2016, and VaR is no longer a term used only by big banks. Today, large and midsized companies are using VaR to take the emotion out of managing risk and helping financial professionals make smarter, better, more proactive business decisions.
Before we move on, some of you may already be wondering, “What is VaR, anyway?” In 1994, JPMorgan and Reuters released RiskMetrics which defined VaR as: “Value at Risk is a statistical technique used to measure and quantify the level of financial risk … over a specific time frame … to determine the extent and occurrence ratio of potential losses.”
The VaR methodology uses existing implied market volatility published by information sources of an underlying asset class. It projects the next logical move in a defined time frame. Using this method, risk managers are aware of potential positive or negative impacts to their existing or projected portfolio positions. And they can then establish triggers and limits to act in line with company policies and procedures.
So how are companies using VaR, specifically? The first step, using implied volatilities in the market, is to calculate a distribution of expected returns for your specific timeframe. Some managers like to look out at the next week, while others look at the next two weeks or the next month.
Next, determine the level of risk you want to assess. For example, if you want to measure 95 percent risk (5 percent chance of losses worse than X), you would sample the distribution of returns at a 95% confidence level. You could then translate that return to a specific price (or prices, in more complicated scenarios). And finally, evaluate your portfolio with that price (or prices).
The natural result is to apply VaR to a forecast or stress test. Ask: What can go right or wrong on today’s existing positions if the market moves like the data is suggesting it could?
This example highlights what is a very real opportunity for many companies: To use VaR to help make proactive decisions about financial risk based on hard-and-fast numbers and statistical analysis.
I know that sounds obvious, especially for financial professionals who work with numbers each and every day. But historically, many businesses make risk management decisions after bad things happen. As a result, these decisions are clouded by an emotional bias. For example, we made a hedging decision last year that did not go well. Our fear of repeating that mistake – of being wrong – prevents us from acting to protect the value of our portfolio from volatility today.
The price of aluminum goes down substantially? Producers decide to store their aluminum and wait for a better price. But then they are reducing their cash flows and operating budgets and reacting to a market condition, not proactively planning for such a price drop. A large purchaser may hesitate to act in this environment for fear they will buy now and the price will drop lower and they will have missed the bottom of the market. No one wants to be wrong. Each of these decisions is based on emotion, not analysis.
As more companies use VaR methodology, it signifies a significant departure from the way organizations have managed risk in the past – this reactive approach. Using VaR is more rational and proactive – looking at the potential or expected moves over a specific period of time, based on forecasts, underlying markets and potential outcomes.
That’s a big shift—and again, opportunity—if you’re a controller, treasurer or risk manager reporting to a CFO or CEO who’s looking to stay one step ahead. It’s your role to prepare senior leaders for potential scenarios and give them options to mitigate risk proactively.
VaR helps do just that—with the support of real numbers. In essence, VaR can help “professionalize your approach to risk.”
I’m curious—is your company using VaR to plan for and better mitigate risk? And if yes, how has that process went compared to your previous process?