We as investors are always concerned about the risk & return on investment.
Being risk-averse investors, we always try to choose security that has low risk and provides a better return as opposed to another security with a higher risk. We end up asking several questions about the risks our portfolio is exposed to, right?
What affects your portfolio? What is the type of risks that affect your portfolio?
Market Risk (Systematic Risk)
Company-Specific Risk (Unsystematic Risk)
Company-Specific Risk is a risk that is inherent in a specific company or industry. E.g. Fall in the share price of Yes Bank or rise in the market price of Reliance. By investing in a range of companies and industries this can be drastically reduced through diversification.
Market risk is a risk that occurs due to a change in the market factors. E.g. the slowdown caused by Covid-19, 2008 market crash etc. Market risk scares the investors because their investment value can decline exponentially when exposed to market risk. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy.
Most banks and management companies try to minimise this market risk with valuable tools. One such tool is VaR- Value at Risk.
What is Value at Risk?
Value at Risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. It measures the maximum loss a portfolio can suffer under such normal market conditions. It provides:
The estimated amount of loss
Probability or chances of that loss
The time horizon (normally short but can be converted into longer horizons)
Now in this figure above, normal conditions which are assumed to occur 95% of times which means that 95% of the times the market performance will be normal with slight ups and downs and no major downfall. There is a 95% probability that losses on this portfolio will not exceed a loss of -0.82%, i.e. the maximum loss that this portfolio can suffer is -0.82% under normal conditions.
But are we worried about the losses under normal scenarios? No. We are worried about the worst-case scenarios which can occur in the remaining 5%. There are 5% chances that these losses will exceed -0.82%.
VaR is like an indicator of the amount of risk your portfolio can bear by providing a reasonable bound. Usually, such tools are used by commercial banks and many investment banks to invest their excess cash into safe securities.
One such incident happened with JP MORGAN CHASE
In 2012, JP Morgan Chase suffered losses amounting more than $6.2 Billion. The Chief Investment Officer (CIO), Bruno Iksil, had to invest the bank's excess funds. He took large positions in derivative markets specifically into insurance like bets called Credit Default Swaps which turned out to be excessively risky. The VaR levels set by the banks acted as an indicator to wind up the position but instead the CIO treated those set VaR levels as overstated. He did not wind up the position of $500 billion, instead hedged this position for a speculative gain of $400 billion. The market acted against these huge positions and the firm ended up making huge losses of $6.2 billion.
The CIO refused to adhere to the VaR limits which could have reduced such losses. The breach of VaR limit along with other reasons lead to aggravated losses for the bank in 2012.
One can check VaR levels before investing in any stock to make an informed decision. For e.g., If I wanted to invest into ICICI Bank with VaR at 5% as -4%, which means there is a 5% possibility of your capital to get eroded by -4% or more in a day. Sounds scary right? This is exactly the reason why risk should be calculated well before investing in stocks or it can erode your capital completely. Also, NSE INDIA provides data of VaR for each company which can be checked before investing. Therefore, don't just be an investor, be a wise investor.
However, VaR as a tool is not perfect:
Assuming the risk of an uncertain event is difficult.
The assumptions entered can lead to underestimation of risk at times, and hence increase losses.
VaR as a tool to estimate financial risk is a blessing in disguise.
Write-up by: Prachi Chhugani
Comments