How Value at Risk (VaR) is Implemented?
In the previous articles, we have discussed the details about the concept of value at risk (VaR) as well as the theoretical calculation of value at risk (VaR). The theoretical portion of the model is easy to understand. However, it needs to be understood that this is not how the model is actually implemented in real life. In this article, we will have a closer look at some of the complications faced while implementing the value at risk (VaR) model.
The Problem of Too Many Asset Positions
Theoretically, the value at risk (VaR) model proposes that each asset should be considered separately. This means that if a company has a hundred different types of bonds, then they should run the value at risk (VaR) model for all of them. However, in real life, this becomes a challenge.
This is because it is common for companies to have hundreds or even thousands of different types of securities. As such, computing the value at risk (VaR) by inputting values for each individual asset becomes a computational challenge. However, nowadays, computing power is available fairly cheaply. Hence, it would be possible for companies to tremendously scale up their computational power without having a proportional impact on their budget.
However, computational power is not the only challenge. If there are hundreds of assets, then the details of these hundreds of assets also have to be entered into the model. Deriving and maintaining data related to hundreds of assets and the various correlations between them can be a challenge. Firstly, a lot of time, money, and resources will have to be allocated to this task. Secondly, the complexity may be needless since spending more time and money may not necessarily improve the accuracy of the model.
Therefore, during the implementation of the value at risk (VaR) model, every company faces the same problem. They need to group assets together in order to reduce the asset types. However, they also need to ensure that the accuracy of the model is not compromised while doing so. Hence, the grouping has to be done in an intelligent manner.
Methods Used to Implement Value at Risk (VaR) Model
Mapping the various assets to risk factors will not be an error-free process. Many times, the organization may not be sure of the mapping. In such cases, they may have to make difficult choices. They must be aware of the two types of errors and their consequences.
The final decision should be taken to minimize the impact i.e. the lower value of type 1 or type 2 error must be selected.
The bottom line is that the practical implementation of value at risk (VaR) models is quite different as compared to the theoretical construct. A lot of different types of challenges may be faced while implementing the model.
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