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Question

Which of the following is a limitation of the Value at Risk (VaR) approach, a widely used risk management tool, to measuring risk?

A It fails to specify the probability that a loss could occur Correct Answer Incorrect Answer
B It fails to specify a time frame for potential loss Correct Answer Incorrect Answer
C It fails to specify the assumptions for estimation of loss Correct Answer Incorrect Answer
D It fails to specify the maximum loss that could occur Correct Answer Incorrect Answer
E None of these Correct Answer Incorrect Answer

Solution

A limitation of the value at risk (VaR) approach to measuring risk is that it fails to specify the maximum loss that could occur. VAR statistic has three components - a relatively high level of confidence (typically either 95% or 99%), a time period (a day, a month or a year) and an estimate of investment loss (expressed either in absolute or percentage terms). However, at a 99% confidence level what VAR really means is that in 1% of cases (that would be 2-3 trading days in a year with daily VAR) the loss is expected to be greater than the VAR amount. Value At Risk does not say anything about the size of losses within this 1% of trading days and by no means does it say anything about the maximum possible loss.

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