How to Calculate Value At Risk

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Value-at-Risk is a method of calculating the maximum potential losses for an investment during a specific time period. The VAR is expressed with a specific degree of confidence in the calculation, the time period for which the calculation was made and the amount of loss in dollars or percentage points. Three main models are used in VAR calculations. However, the simplest model that does not require additional software or complicated calculations is the Historical Method. This approach compiles the historical daily returns of a stock in a histogram from worst to best and interprets the VAR from the resulting graph.

Compile the historical daily return data on the stock you wish to analyze. This information is readily available from many websites, such as the New York Stock Exchange, NASDAQ, Yahoo and MSN. The more information available, the more accurate the VAR calculation will be.

Arrange the returns in order from worst to best to form a histogram of the data. Plot the number of times a particular return amount appears on the y-axis and the percentage of the return on the x-axis. The resulting graph will be a bar graph that has a left tail in the negative return range for most stocks and a right tail that tapers off in positive returns, with the majority of the results falling in the middle of the two.

Look at the numerical values of the lowest 5 percent of the overall historical returns to find the first VAR statement. For example, imagine that the lowest 5 percent of the returns fall between 6 and 8 percent. The VAR statement would be, with 95 percent confidence, that the worst daily loss will not exceed 6 percent.

Consider the numerical values of the lowest 1 percent of the histogram to determine the second VAR statement. If the lowest 1 percent of daily returns is between 9 and 10 percent, we can say that, with 99 percent confidence, the worst daily loss will not exceed 9 percent.

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