Capital at Risk and 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 Value at Risk and How Is It Calculated?

Value at Risk (VaR) is a financial formula used to determine a worst-case investment scenario over a particular time frame.

For example, if you have a 95% one-day VaR of $10,000, there is a 5% chance that your minimum loss will be $10,000 in a single day. This is a worst-case scenario.

From a different perspective, this VaR means you can be 95% confident that your losses will not exceed $10,000 in a single day.

There are three different analytical techniques for determining VaR.

The Historical Method

The historical method assumes that historical price actions will repeat themselves, and thus relies on the historical returns of the investment to calculate VaR. Returns are placed in an ordered list, from the worst-performing return to the best-performing return.

For example, suppose that you wanted to determine the one-day 97% VaR for a hypothetical cryptocurrency “ToolCoin” using 100 days of historical pricing data. Using the historical method, you would study the last 100 days of ToolCoin’s price action. You would order these prices from the worst pricing day to the best, similar to the hypothetical table below:

The 97th percentile VaR in this hypothetical case corresponds to the third-worst return, which is a price drop of 11.12%. Therefore, ToolCoin’s risk can be represented as having a 1-day 97% VaR with a loss of 11.12%. That means there's only a 3% chance your ToolCoin investment will drop more than 11.12% in a single day. In other words, you can be 97% confident that your potential ToolCoin losses will not exceed 11.12% in a single day.

If you think this is an acceptable level of risk, then ToolCoin would be an attractive investment option for you. However, before you invest in ToolCoin, you might want to consider using this same VaR calculation method for other cryptocurrencies to compare risks.

One advantage of the historical method is that it is relatively straightforward to compute.

One disadvantage of this method is that it assumes current and future risks can be based on past price actions. Therefore, this method is rather static when it comes to fluctuating market dynamics.

The Parametric Method

The parametric method, also known as the variance-covariance method, calculates VaR as a function of the mean and variance of historical returns.

This method assumes a normal distribution of returns and requires that you determine three criteria before you can compute VaR:

 

1. An expected or average return

2. Your data set's standard deviation

3. The amount of your investment With these three values, you can then plot your normal distribution, which would look something like the graph below: 

Normal distribution of investment results

(Source: futurelearn)

Positive investment results or gains are represented to the right of the peak, towards the positive tail end of the curve. Negative investment results or losses are represented to the left of this peak.

The point on the above graph marked as "VaR" represents the calculated worst-case scenario given the three criteria. Let’s assume that this computed VaR is 3%. For this normal distribution, there is then a 97% (1 – (3% or 0.03)) probability of achieving investment results greater than the computed VaR.

And there is a 3% probability of achieving investment results that are less than the VaR.

The Monte Carlo Method

The Monte Carlo method uses a software algorithm to create a large number of hypothetical simulations. Data that must be input into the software includes historical returns and standard deviations of the investment. The algorithm then runs a large number of scenarios to come up with the investment's potential positive and negative price actions.

One disadvantage of this method is that the software generating the simulations may be slow based on the number of different inputs and calculations that need to be computed.

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. Any opinions, news, research, analyses, prices, or other information contained on this website is provided as the general market commentary of Thomas Wettermann and does not constitute investment advice. Thomas Wettermann will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from the use of or reliance on such information. All opinions expressed on this site are owned by Thomas Wettermann and should never be considered as advice in any form.