S/F/85. Comparison of the three investment models used by financial institutions to evaluate risk exposure; VAR, Monte Carlo and Historical methods

Information from the banks trading activities and measurements are put into models, which then provide the extent to which the bank is exposed to market risk. This is known as Value at Risk (VaR), it summarises the potential risk of a financial instrument in a one figure. ‘So-called value-at-risk (VAR) models determine the amount of capital that banks must set aside against their trading positions, and purport to show how many millions of dollars a bank might lose should markets turn against it’ (The Economist ‘The coming storm’). VaR has three components, a time period, a confidence level and the resultant estimate of future loss. VaR is a recommended method of calculating risk by the Bank of International Settlements (BIS).There are three methods that a bank can use to measure the capital they require to cover their market risk exposure: Variance / Covariance, Historical and Monte Carlo