First things first... What is VaR?
VaR is one way of trying to gauge your portfolio’s potential loss over a defined time frame at a specified level of confidence. You can calculate VaR using past portfolio performance, or you can create a model with this data and various risk parameters that adjust for your economic outlook to generate a probable outcome.
However you calculate VaR, the result is the downside cut-off point, as determined by the confidence level, or how much of the potential performance should be above or below this cut-off during your defined time frame.
In other words, if you set your confidence level at 99% and your time frame is 10 days, you would expect your performance over that time frame to be better than the formula result 99 times out of 100, and 1 time in a hundred your portfolio will do worse.
Now, you may be wondering why should I care about VaR?
Some of you are thinking ‘Wow, this seems more complicated than I want to deal with.’ While some are saying ‘VaR is not complicated enough to
effectively manage my portfolio risk.’ Well, the reason all of you should care is because the Securities and Exchange Commission said so, that's why.
In August 2022, rule 18f-4 took effect. This rule requires that managers of registered funds using derivatives, like futures or swaps, to use at least 3 years of data to calculate VaR daily and then check that day's actual results against your daily VaR figure.
The rule came about as a result of the SEC’s review of the circumstances leading to the 2008 Great Financial Crisis and the role that derivatives played. A derivative is simple in that it is an investment that gets, or derives, its value from another investment that is market priced. Where it gets complicated is how these degrees of separation from the initial price source magnify the impact a derivative investment has on your portfolio.
VaR is the SEC’s way to ensure that managers are trying to understand the downside risk from derivatives to their portfolio.
To see if your portfolio is in compliance or to set up a strong monitoring program contact us