The COSO Framework for Internal Control
February 12, 2025
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The value at risk (VaR) model has several advantages, which is why it is used widely in different parts of the world. However, the model also has some very distinct disadvantages. The existence of these disadvantages does not mean that the model should not be used. It is still one of the best tools at our disposal when it comes to market risk management. However, it is important for risk management practitioners to be aware of the possible risks of the value at risk (VaR) model since ignoring those risks can lead to disastrous consequences in the long run.
Even if a company calculates the value at risk (VaR) at a 99% confidence level, there is still a chance that the actual loss will be greater than the value at risk (VaR) number 1% of the time. 1% of the team means that on average, a trading loss will exceed the expected amount 2-3 times in a year! Also, the value at risk (VaR) model does not provide any information about the extent to which this loss will exceed the calculated number.
In many cases, catastrophic events may occur and the actual loss may exceed the expected loss by a huge amount. In some severe cases, the solvency of the firm may also be threatened by sudden huge losses. It is therefore important for the firms to realize that there is a huge difference between 99% confidence level and 100% confidence level. Not knowing the difference can cost them the existence of their firm.
For instance, it is common to assume that the losses have a normal distribution and make the calculations accordingly. However, in many industries, it may not be true. In some market scenarios using the binomial distribution may be more beneficial as compared to the normal distribution.
The end result is that the values given by the VaR model are quite subjective. It is possible for the management to understate or overstate some risks simply by tweaking some of the assumptions in the VaR model.
Hence, when the number of assets increases, the correlations that have to be taken into account also increases. This can become mathematically challenging. The software programs used to calculate the value at risk number usually have a limitation when it comes to the maximum number of assets in the portfolio.
However, the value at risk value cannot simply be adjusted for the portfolio changes. Instead, it has to be calculated from the very beginning. Even though technology helps in quickly calculating the value at risk, this poses several difficulties in the day-to-day management of the firm.
Based on the above arguments, it would be fair to say that the value at risk (VaR) model has its own fair share of limitations. However, it would also be fair to say that these limitations do not completely undermine the benefits provided by this model. This is the reason why the value at risk number is extensively used. However, the risk management practice is considered more prudent if the limitations posed by this model are understood before using the output generated in the decision-making process.
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