VaR as a measure of downside risk
VaR or Value-at-risk is a method of measuring the downside risk or potential loss for a portfolio or an investment over a given period of time and helps in analysis and estimation of how much the minimum loss can be with some pre-determined confidence. It is a statistical measure of the risk in a portfolio.
For example, VaR can tell us that in 1 out of 21 days, an investor can expect to realise a loss of at least 3% of the total portfolio value. Thus, it helps determine the amount of potential loss, the probability of that amount of loss and the time frame.
There are various methods to calculate VaR using statistical simulations. The risk management department of a firm monitors this parameter closely and tries to ensure that risks are not taken beyond a certain level of probable worst outcome.
Traders in the equity markets also need to have a certain amount of money as margin money in order to help cover losses on their trades. It is, however, difficult to estimate the margin required to sufficiently cover all the losses if the market presents the worst-case scenario. As such, a standardised system to calculate such margin money amount has been developed which is adopted by most traders, called the SPAN or Standardised Portfolio Analysis of Risk.
SPAN system takes into account complicates algos and machine learning techniques to calculate margin amounts for each single position, equivalent to the maximum loss a single account can reasonably incur in a single trading day. It was developed by the CME in 1988 and over 50 exchanges globally use SPAN as their official methodology to calculate margin requirements. This margin is different for different securities as they all have varying risks associated with them. For instance, SPAN margin for a single stock will be higher than that of an Index given the higher risk and volatility associated with a single stock.
Every successful trader knows the importance of managing risk – which is even more important than returns. VaR and SPAN calculations enable a trader to responsibly hold many contacts in the portfolio and avoid serious margin calls.
Today, more brokers and financial institutions are focussing on better risk management practices. Many of them require that in addition to SPAN margin, which is collected at the time of initiating trades, an additional margin known as Exposure margin be collected in order to protect against liabilities arising from wild swings or rogue trades or extreme-stress market reactions.