Written by: Chandrakant Maheshwari and Pooja Chandra
The Value at Risk (VaR) framework is now an industry standard to measure the risk associated with a given portfolio of financial instruments. VaR finds favor because it is easy to understand. It is simply one number which gives you a rough idea about the extent of risk in the portfolio. It is measured in terms of price units (dollars, euro) or as a percent of the portfolio value. Value at Risk is applicable to stocks, bonds, currencies, derivatives, or any other assets with price. This is why banks and financial institutions like it so much – they can compare profitability and risk of different units and allocate risk based on VaR (this approach is called risk budgeting).
Risk Not in VaR (RNIV)
While VaR has found favor in part because it is easy to understand, it is simplification of real world. The main behavior of the real world is captured but some features are discounted to avoid making the model too complex and also because historically they never played a crucial role.
The financial crisis of 2008 proved that some previously ignored data behaviors – e.g., a tenor adjustment on a basis swap can suddenly and significantly contribute to a catastrophic event. Tenor adjustments were ignored in many VaR models. It is a premium expected by a party which pays coupons at a higher frequency then its counterparty.
When two parties enter into a swap agreement where one party makes a monthly payment and the other pays quarterly, a tenor adjustment occurs. The party that pays monthly and receives quarterly will face credit risk. Hence that party demands a premium in its quarterly received coupons.
Prior to 2008, the risk of a basis swap was quite minimal. Indeed, primarily because of liquidity concerns, spreads in 1 month and 3 month swaps in the US were just .25 basis points (bps). Consequently, basis swap risk was mostly ignored in VaR models.
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