Market Risk Measurement - VaR and Beyond › Market Risk Measurement - VaR and Beyond

The collapse of Barings Bank in 1995 and the near-failure of Long-Term Capital Management in 1998 demonstrated that even sophisticated financial institutions could face catastrophic losses from market risk exposures they poorly understood. These events accelerated the adoption of Value-at-Risk (VaR), a deceptively simple metric that answers a question every risk manager needs answered: "How bad could things get?"

VaR distills the complexity of a portfolio's risk exposures into a single number representing the maximum expected loss over a specified time horizon at a given confidence level. If a portfolio has a one-day 99% VaR of $10 million, this means that under normal market conditions, the portfolio should not lose more than $10 million in a single day with 99% probability. Equivalently, losses exceeding $10 million should occur only about 1% of trading days, or roughly 2-3 times per year.

The Basel Committee on Banking Supervision embedded VaR into the regulatory framework for bank capital requirements in 1996, cementing its role as the industry standard for market risk measurement. However, the 2008 financial crisis exposed serious limitations: VaR tells you where the cliff is but not how far you might fall. This chapter develops VaR from first principles, implements the three major calculation methods, and then moves beyond VaR to Expected Shortfall and stress testing techniques that address its shortcomings.