Value At Risk | Philippe Jorion

Summary of: Value At Risk: The New Benchmark for Managing Financial Risk
By: Philippe Jorion

Introduction

Value at Risk: The New Benchmark for Managing Financial Risk by Philippe Jorion introduces the concept of Value at Risk (VAR) as a fundamental strategy for measuring and controlling market risks. The book discusses the invaluable role of VAR in addressing the risk management challenges faced by financial institutions, regulators, and multinational corporations. By presenting the various methods for calculating VAR such as delta-normal method, historical-simulation method, stress testing, and structured Monte Carlo analysis, the author provides readers with an overview of the strengths and weaknesses of each method, as well as their practical applications. The book also highlights the potential dangers for organizations that fail to properly monitor and manage their risks, using real-world examples of Barings Bank and Orange County.

Managing Financial Risk with Value at Risk (VAR)

The book excerpt discusses the importance of Value at Risk (VAR) in managing financial risk and avoiding bankruptcy. The bankruptcies of Barings Bank and Orange County highlight the impact of volatile derivatives trading, which could have been avoided with VAR. VAR helps measure and control market risk by calculating the worst-case scenario for a portfolio by measuring the largest expected loss in a specific time period at a particular confidence level. It allows corporations to communicate financial risk, allocate capital, set position limits, and measure performance adjusted for risk. Multinationals, regulators, and asset managers can use VAR to mitigate risk, but users must understand its limitations. With its ability to measure the probability of money-losing market moves and assess exposure, VAR is a significant improvement over traditional risk measures.

The book excerpt emphasizes that the bankruptcies of Barings Bank and Orange County illustrate the impact of volatile derivatives trading. To address such risks, the book suggests using Value at Risk (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 specific time period at a particular confidence level. It could have helped entities like Orange County and Barings Bank avoid bankruptcy.

Using VAR has several advantages, including simple communication of financial risk to managers and shareholders, helping to allocate capital and set position limits for traders, and measuring performance adjusted for risk. Financial institutions, regulators, and asset managers can use it to mitigate risk, and even non-financial companies like multinational corporations can take advantage of it.

While VAR is an improvement over traditional risk measures, users must understand its limitations. The book warns that each of the four methods of calculating VAR has strengths and weaknesses, and it isn’t perfect. Nonetheless, VAR’s ability to measure the probability of money-losing market moves and assess exposure makes it highly valuable.

In summary, managing financial risk is vital, and the book suggests using strategies like VAR to mitigate risk. With its ability to calculate the worst-case scenario for a portfolio and measure performance adjusted for risk, VAR provides a significant improvement over traditional risk measures. However, users must understand its limitations to take full advantage of its benefits.

VAR: A Single Number That Forecasts Market Risk

The book highlights how the Barings PLC and Orange County financial collapses demonstrate the importance of monitoring market risk using Value at Risk (VAR). VAR provides a clear understanding of an institution’s total exposure to risk by summarizing it into a single number. The rogue trader Nicholas Leeson lost $1.3 billion in 1995 trading derivatives from Barings’ Singapore office. Barings officials did not supervise Leeson closely, and a closer look at the numbers shows that if they used VAR, they would have been warned of the potential for huge losses. Similarly, Bob Citron managed a $7.5 billion portfolio for California’s Orange County and leveraged the cash, investing it in reverse repurchase agreements. As interest rates began to rise, the county began to lose money, leading to a loss of $1.6 billion. The book’s message is that risk management entails making predictions about changes in risk factors and VAR provides an excellent tool to forecast market risk.

Derivatives and Swaps

The book discusses financial engineering and its creation of derivatives as a risk-management tool in international markets. Derivatives are private contracts that derive their value from underlying assets such as stocks, bonds, currencies, or commodities. The most basic types of derivatives are forward and futures contracts that exchange an asset at a given time. Derivatives are different from investments because they don’t offer dividends or voting rights. Despite their market risk, derivatives have become a $50 trillion market, larger than the United States’ gross national product. Swaps, another type of derivative, exchange cash flows in the future. Currency swaps let institutions that need to borrow in foreign currencies hedge risk, and interest-rate swaps allow bondholders to change cash flows from fixed to floating or vice versa.

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