1.6 Value-at-Risk Applications

1.6  Other Applications of Value-at-Risk

In addition to supporting risk limits, value-at-risk is used for a variety of purposes, including:

1.6.1 Risk Reporting and Oversight

Most organizations that trade—especially larger or regulated entities—have some form of financial risk management function. This will involve dedicated staff—perhaps a head of risk management or an entire risk management department. There will be executive-level and/or board-level risk committees to whom that staff reports. Staff prepares a periodic risk report for those committees. These may detail value-at-risk for each business unit, desk or trader that has a VaR limit as well as other information—such as trading P&L, new sales or risk limit violations—for each. The report may include charts of how value-at-risk has recently evolved. Other information may relate to credit risk, liquidity risk, operational risk, etc.

1.6.2 Bank Regulatory Capital Requirements

Since the 1980s, bank regulators have downplayed direct regulation of bank activities, focusing instead on requiring banks to hold capital to cover the risks associated with the activities they choose to engage in. Capital requirements are specified in a series of international agreements called the Basel Accords. These are administered by each nation’s domestic regulatory authorities. A 1996 amendment to the original Basel Accord specified capital charges for market risks as measured by value-at-risk. For calculating those charges, banks can use a crude methodology specified under the Accords, or they can, with their regulators’ approval, use their own proprietary value-at-risk measures with a 10-day 99% VaR metric. Due to the practical challenges of modeling intra-horizon events, this is calculated as one-day 99% VaR and then scaled by the square root of ten—essentially assuming a static portfolio for ten days and independent daily P&L’s.

1.6.3 Economic Capital Calculations

Some banks supplement their regulatory capital calculations with internal capital calculations based on propriety formulas designed to more accurately reflect the firm’s views on the riskiness of its various activities. Called economic capital calculations, these may employ value-at-risk to quantify market risks.

Economic capital is used to assess the performance of business units within an organization on a risk-adjusted basis. Various formulas are used for this purpose, but the idea is to divide some measure of a unit’s profits for a given period by the economic capital that was used by the unit to achieve those profits. Economic capital may also be used to assess proposed transactions, similarly dividing some measue of anticipated profits from a transaction by the economic capital required by the transaction. Such techniques were pioneered by Bankers Trust with their risk-adjusted return or capital (RAROC) methodology during the 1980s.

While economic capital originated with, and is primarily used by, banks, other trading organizations use it. Energy trading powerhouse Enron, which failed spectacularly in 2001, was known to use economic capital.

1.6.4 Corporate Disclosures

Item 305 of the SEC’s Regulation S-K requires that large US corporations disclose certain qualitative and quantitative information on market risks arising from interest rates, foreign exchange, commodities, and other sources. Quantitative information can be presented as tabular data on individual positions, a sensitivity analysis, or value-at-risk.

1.6.5 Risk Budgeting

Institutional investors—as well as the investment managers and consultants who advise them—have long incorporated techniques of portfolio optimization and asset allocation into their investment process. These techniques require some metric of market risk. Standard deviation of simple return is generally used for this purpose. There has been experimentation with using value-at-risk instead, in which case the activities have been called risk budgeting.

1.6.6 Other Applications

While the above may represent the primary applications of value-at-risk, almost any application that requires a metric of market risk might employ value-at-risk. Examples include hedge optimization or optimizing the tracking error of a portfolio against some benchmark.