When the firms go for hedging or any kind of trading decisions, they make it a point to consider value at risk. In other words, the value at risk is a risk metric category that measures the market risk associated with portfolio trading with the help of the probability theory. The application of value at risk technique is broad in finance and economy.
The value at risk technique is primarily used by security firms, banks and companies that are involved in the business of energy and other commodities trading.
These firms could also determine the market risk of their portfolios by using the value of historical volatility of the market as a risk metric. This is done by working out the historical volatility of the market value of their portfolio over 100 trading days. This technique, however, suffers from some disadvantages. This calculation gives an overview on how the portfolio was risky over last 100 days but it does not say anything on its being risky at the current time or in the future. The value-at-risk metric is more prospective than the retrospective risk technique like historical volatility.
The institutions that want to manage the risk of their portfolio need to know about risks that they are considering. In the cases when a portfolio is mis-hedged by a trader, the employer of the trader has to find out it before the loss is occurred. The technique of value-at-risk gives the institutions this ability to determine risks at this level. The value at risk has the capacity to estimate the market risk at the time it is being taken.
The three models that are used in order to calculate VaR are as follows:
- Monte Carlo simulation
- Historical simulation
- Variance-Covariance Model
