Value-at-risk (VAR) is a probabilistic measure of the range of values a firm’s portfolio could lose due to market volatility. This volatility includes effects from changes in interest rates, exchange rates, commodities prices, and other general market risks. A typical reporting of VAR would be the following statement: “There is a 5% chance the bank will lose more than $5 million over the next trading week.” Thus VAR is simply a statement of probable loss.
J.P. Morgan Chairman Dennis Weatherstone demanded a simple report at the end of each day on how the firm’s position could change due to market risk. Morgan analysts came up with VAR as this measure and incorporated it into what became known as the 4:15 report, the report was given to Weatherstone daily at that time to summarize the day’s market events.
The Washington-based Group of Thirty, in a 1993 study headed by Weatherstone, Derivatives: Practices and Principles, recommended using VAR as a means of identifying a firm’s overall market risk. Since then, VAR has skyrocketed in popularity and there are few financial institutions which do not envisage making it part of their day-to-day reporting. In fact, many financial regulators, such as the European Economic and Monetary Union, require banks to report their VARs on a regular basis.
Because there are a variety of ways to calculate VAR, J.P. Morgan sought to make its method the industry standard. In 1994 it began giving away copies of RiskMetrics, a program it developed to calculate VAR. Morgan’s Internet web site includes a RiskMetrics section, where individuals or firms can download parts of the program. This initial move into the VAR market did not stop other investment banks from creating their own VAR calculation programs and peddling them to other financial organizations. Many of these programs differ from RiskMetrics, and while RiskMetrics is widely recognized in VAR measurement, the industry has yet to settle on a single calculation method.