Value at Risk (VaR) is a statistic that quantifies the extent of possible financial losses within a position over a specific time frame. It is generally communicating how much of your value can be lost and what the probabilities are that it will be lost.
For example, if we say your portfolio has a 10% one-month VaR of 5% it means, there is a 10% chance of your portfolio losing a minimum of 5% of its value during that one month.
There are several ways to calculate VaR:
-Monte Carlo Simulation
We will likely cover these methods in depth in a future article.
Unfortunately, predicting the future is still impossible and any statistical model that attempts to do so must make assumptions. VaR calculations often fail to account for “Black Swan” events, wherein unpredictable events have outsized repercussions. Also, VaR assessment represent the lowest risk of a range of outcomes. In our previous example, if your portfolio lost 50% of its value the VaR would still be considered accurate. The VaR stated you would lose at minimum 5%.
While in some ways flawed, VaR is a powerful risk assessment tool. Its use in risk management in crypto markets is still in its infancy. Stay tuned as we continue to experiment with techniques for managing and assessing the risks of crypto markets.