Lesson 60 - Advanced Accounting Course

Lesson 60: Quantifying Financial Risk Using Value at Risk (VaR) Models

🧠 What Is Value at Risk (VaR)?

Value at Risk (VaR) is a quantitative risk management tool used to estimate how much a company, portfolio, or investment could lose over a specific time period with a certain level of confidence.

📉 It answers the question:
“How much money could I lose in the worst-case scenario (within a specific confidence level)?”

🔍 Key Components of VaR

📦 Example

A company calculates its 1-day VaR at 95% confidence level = $1 million

✅ This means:
There’s a 95% chance the company won’t lose more than $1 million in one day,
and a 5% chance it will lose more than that.

📐 Common Methods to Calculate VaR

🧾 Quick Formula (Variance-Covariance Method)

For a single asset or portfolio:

VaR = Z × σ × √T

Symbol Meaning

Z : Z-score (based on confidence level, e.g., 1.65 for 95%)

σ : Standard deviation of returns

√T : Square root of time (in days, etc.)

📘 Example:
Standard deviation = 2%
Confidence level = 95% → Z = 1.65
Time = 1 day

📉 VaR = 1.65 × 2% × √1 = 3.3%
So, there's a 95% chance the asset won’t lose more than 3.3% of its value in one day.

🧠 Why VaR Is Important in Accounting and Finance

❗ Limitations of VaR

• 🚫 Doesn’t predict extreme losses ("tail risk")
  
  

• ⚠️ Relies on assumptions (e.g., normal distribution)
  
  

• 📉 Not useful alone — should be part of a broader risk management strategy

✅ Summary Table

👩‍🏫 Final Thought

VaR is a powerful tool, but it’s not magic.
👉 It helps quantify risk, but companies still need judgment, experience, and complementary models (like stress testing or Expected Shortfall).