Capital at Risk and Conditional Value at Risk

With extensive experience as an electrical/software/coding engineer along with having a diverse financial background, Thomas Wettermann’s areas of interest include Machine Learning (ML), artificial intelligence (AI), and Financial Technology (FinTech).  For the past few years, Thomas Wettermann has focused on the underlying technologies that support and promote all phases of cryptocurrency ecosystems.

What Is Capital at Risk?

Capital at Risk (CaR) is an amount of capital that an individual or corporate entity sets aside to cover potential risks.

For example, an insurance company typically receives premiums in cash. However, these companies are also required to maintain a surplus amount of cash in case they are forced to pay for losses and expenses that exceed the premiums collected. The amount of this surplus is called the capital at risk. The amount of capital at risk that insurance companies must set aside is determined by the number of estimated claims and the quantity of paid premiums.

CaR is also important under the US federal income tax code, particularly to those taxpayers seeking favorable tax treatment for their capital gains. To be afforded this favorable tax treatment, the IRS requires investors to have an amount of capital at risk in the underlying investment. This amount is dictated by the Internal Revenue Service (IRS) and the federal income tax code.

What Is Conditional Value at Risk?

Conditional value at risk (CVaR) is related to value at risk (VaR). CVaR represents a tail-end financial risk metric. It provides an idea of the scope of losses that might be experienced once losses have exceeded the VaR. Unlike VaR, CVaR is an average of the losses over a certain time period.

The graph below illustrates a normal distribution of investment results. Both VaR and CVaR are represented as losses, towards the left (negative) tail end.

Calculated VaR and CVaR Values (Source: Zephyr)

Rather than a point on the graph, CVaR represents the average loss given by the area under the curve in the “tail” portion of this normal distribution.

What Are the Advantages of VaR?

There are a number of advantages to using VaR when evaluating investment risk. For example, VaR is a relatively straightforward evaluation method since it provides a single number representing a risk level. This single number can either be currency units (e.g., $10,000) or a percentage (e.g., 3%).

Another advantage is that VaR can be used to assess various investment types. For example, VaR can be used for stocks, bonds, derivatives, cryptocurrencies, and so on.

VaR is also a globally accepted risk metric used by multiple financial industries and communities. This commonly accepted metric makes it easy to compare investment options from different industries.

What Are the Disadvantages of VaR?

One of the disadvantages of VaR is that it is not additive for different types of investments in a single portfolio. That is, you cannot add a computed VaR for a first investment type (e.g., stocks) to a computed VaR for a second investment type (e.g., bonds). If you want a value that represents the entire portfolio's VaR, you must compute VaR based on the portfolio as a whole.

In addition, sometimes the underlying data required for the VaR computation is not available or is difficult to accurately estimate. For example, for newer cryptocurrencies, historical price actions may not be available. And for certain other investment classes, it may be difficult to estimate the standard deviation for the correlation method or the various inputs required for a Monte Carlo simulation.

And finally, because the VaR may be computed by the three different methods described above, these different methods can lead to different VaR values for the same investment. In such a scenario, you might consider using alternative risk assessment methods such as the Sharp Ratio or Beta.

Conclusion

CaR and VaR are popular financial risk assessment and risk management tools. CaR is essentially capital that is set aside to cover future potential losses. As noted, CaR should not be confused with capital risk or risk capital.

VaR, on the other hand, is a metric you can use to consider a potential worst-case investment scenario. VaR is a well-accepted risk assessment method and is quite flexible, as it can be used for different asset classes. But VaR also has certain limitations, so you should weigh both its advantages and disadvantages when evaluating your investment risks.

All the views expressed on this site are those of Thomas Wettermann and do not represent the opinions of any entity whatsoever with which Thomas Wettermann has been, is currently, or will be affiliated.

Trading digital financial assets such as cryptocurrencies can carry a high level of risk, and may not be suitable for all investors.  Before deciding to invest, purchase, and/or trade cryptocurrency you should carefully consider your investment objectives, level of experience, adversity to risk, and volatilities.  The possibility exists that you may sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose.  You should be aware of all the risks associated with cryptocurrency trading, and seek advice from a qualified and independent financial advisor.  Thomas Wettermann is not an independent financial advisor. 

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