The COSO Framework for Internal Control
February 12, 2025
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Value at Risk (VaR) is the most prominently used methodology when it comes to gauging and mitigating the market risk. Over the years, this methodology has been extensively used by financial as well as non-financial organizations. It has also been extensively used and recommended by academicians and researchers. The immense popularity of the value at risk (VaR) model can be attributed to some distinct advantages this model provides over other competing models. In this article, we will have a look at some of these advantages.
However, we now know that the sum of individual risks does not always equal the portfolio risk. This is because some correlations also have to be accounted for while coming up with the portfolio risk. Since value at risk (VaR) is only a single number, it is quite easy to communicate this with different people in the organization. It is also easy to automate the risk management system.
The management can then decide whether or not they are willing to take the maximum loss mentioned by the value at risk (VaR) model. If not, they can take measures to offload some of their investments and hence reduce their market risk.
Hence, comparing their risk levels using traditional methods will be difficult. This is where the value at risk (VaR) model is very helpful. Organizations can easily compare their risks with other organizations even though they may be engaged in a completely different line of business.
Also, the fact that value at risk (VaR) is recommended by Basel and other international regulators also adds to the list of reasons why it is widely used. Hence, if an organization tries to use a different risk assessment and mitigation model, it will be difficult since all its peers are already using the value at risk (VaR) model.
The end result is that organizations do not need highly trained statisticians to help them calculate VaR. Instead, regular employees working at the firm can be trained to calculate the number with the help of advanced software.
Many regulatory bodies have made it mandatory for banks to create a VaR model and then allocate risk capital based on the results of this model. This can be thought of as being an endorsement of the validity of the model. The endorsement of industry-leading supranational organizations has definitely lead to increment in the popularity of this model
The bottom line is that value at risk(VaR) is a tried, tested, and effective method to gauge and mitigate market risk. It has been used for many years because of the many advantages that it provides.
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