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Value at Risk

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Value at Risk

The New Benchmark for Controlling Derivatives Risk

McGraw-Hill,

15 min read
10 take-aways
Text available

What's inside?

Money managers who need to gauge the downside of sophisticated derivative investments must study this thorough and complex book; the rest of us can just peruse its intriguing sagas of financial disaster, take an aspirin and lie down.

Editorial Rating

6

Qualities

  • For Experts

Recommendation

As demonstrated by the bankruptcies of Britain’s Barings Bank and Orange County, Calif., any organization that dabbles in derivatives investments needs sophisticated risk-assessment tools like "Value at Risk." The concept of VAR is simple - this single number shows just how much an institution’s investment portfolio stands to lose. But calculating VAR is anything but simple, as author Phillippe Jorion’s complex formulas and dense prose illustrate. Jorion does an admirable job of explaining exactly why Barings went broke, but his book is not for the uninitiated. Without skipping a beat, Jorion throws around impenetrable phrases like "generalized autoregressive heteroskedastic model." Nevertheless, getAbstract recommends this necessarily complex book to money managers who need to gauge the downside of sophisticated derivative investments; the rest of us can simply peruse its intriguing sagas of financial disaster, take an aspirin and lie down.

Summary

The derivatives-related bankruptcies of entities such as Orange County, California, and Barings Bank show just how volatile derivatives can be.

England’s Barings Bank collapsed in 1995 after a rogue trader lost $1.3 billion on derivatives. Orange County went bankrupt in 1995 after losing $1.6 billion in the derivatives market. Barings was undone by fraud, while rising interest rates buried Orange County. Both could have benefited from knowing about value at risk, or VAR - a strategy for measuring and controlling market risks. VAR calculates the worst-case scenario for a portfolio by measuring the largest expected loss in a certain time period at a specific level of confidence.

Consider a bank with a trading portfolio. The institution might say that its VAR is $35 million at the 99% confidence level. In other words, in a normal market, there is only a 1% chance that the bank will lose more than $35 million. J.P. Morgan reported in 1994 that its daily trading VAR was $15 million at the 95% confidence level. While measuring risk is nothing novel, examining an entire portfolio’s potential downside is a new concept. VAR has several advantages:

  • It’s a simple way...

About the Author

Philippe Jorion  is a professor of finance at the University of California at Irvine. He has a Ph.D. from the University of Chicago. He is author of Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County.

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