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What is Value at Risk (VaR)? - Meaning & Calculation Methodologies

VaR is a single number (currency amount) which estimates the maximum expected loss of a portfolio over a given time horizon (the holding period) and at a given confidence level.

VaR is defined as an estimate of potential loss in a position or asset/liability or portfolio of assets/liabilities over a given holding period at a given level of certainty.

The following are the three main methodologies used to calculate VaR:

Parametric Estimates - Estimates VaR using parameters such as volatility and correlation. Accurate for traditional assets and linear derivatives, but less accurate for non linear derivatives.

Monte Carlo simulation - Estimates VaR by simulating random scenarios and revaluing positions in the portfolio. Appropriate for all types of instruments, linear and non linear.

Historical simulation - Estimates VaR by reliving history; takes actual historical rates and revalues positions for each change in the market.

(Source: RBI)

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