Defining Value-at-Risk

An experienced finance professional based in New Jersey, Rao Chalasani most recently served as chief technology officer and director of trading risk management for Bank of America-Merrill Lynch in New York, NY. At Bank of America (BofA), Rao Chalasani developed a new risk management system that incorporated calculation of value-at-risk.

By definition, value-at-risk, or VaR, calculates the maximum loss under a determined probability in a specified time frame. The calculation of VaR requires the pre-selection of a probability percentage, a specified period of time, and a currency. Together, these three elements make up the value-at-risk metric.

As an example, an investment firm calculates the VaR on an asset at $100 million with a one-week, 95 percent confidence level. Under this metric, the investment firm may determine that an asset’s value is only 5 percent likely to drop more than $100 million over the course of one week. This determination can help an investor or manager compare the potential impact of an asset on a trading portfolio.

An analysis of available reserves and capital can determine the effect of the potential loss and help an institution determine whether an event would have a severe impact on capital. The technique can also be helpful in determining the risk to a complete portfolio or a firm as a whole.