To further illustrate the concept of var assume you

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To further illustrate the concept of VaR, assume you have gathered 1,000 monthly returns for a security and produced the histogram shown in Figure 1. You decide that you want to compute the monthly VaR for this security at a confidence level of 95%. At a 95% confidence level, the lower tail displays the lowest 5% of the underlying distribution’s returns. For this distribution, the value associated with a 95% confidence level is a return of –15.5%. If you have $1,000,000 invested in this security, the one-month VaR is $155,000 (–15.5% × $1,000,000). Figure 1: Histogram of Monthly Returns
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Page 4 ©2015 Kaplan, Inc. Topic 1 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 1 Professor’s Note: This calculation is an example of historical VaR. In Book 4, we will discuss the main types of value at risk: delta-normal VaR, historical VaR, and Monte Carlo simulation VaR. Economic capital refers to holding sufficient liquid reserves to cover a potential loss. For example, if one-day VaR is $2.5 million and the entity holds $2.5 million in liquid reserves, then it is unlikely to go bankrupt that day. Qualitative Assessment Scenario analysis takes into account potential risk factors with uncertainties that are often non-quantifiable. One option is to consider an adverse scenario or worst-case scenario analysis to get an idea of the full magnitude of potential losses even if they have a very small chance of occurring. Worst-case scenario analysis involves examining the effects of possible macroeconomic scenarios on the entity and within its various divisions, often taking into account several categories of risk. Stress testing is a form of scenario analysis that examines a financial outcome based on a given “stress” on the entity. For example, it is plausible for interest rates or unemployment rates to rise severely in an economic crisis and stress testing attempts to examine such crisis situations to determine the outcome on the entity. Enterprise Risk Management (ERM) ERM takes an integrative approach to risk management within an entire entity, dispensing of the traditional approach of independently managing risk within each department or division of an entity. ERM considers entity-wide risks and tries to integrate risk considerations into key business decisions. Similar to traditional approaches, ERM makes use of measures such as economic capital and stress testing. Senior risk committees may exist within the entity to ensure that risks affecting the entire entity are examined. Within the ERM framework, the entity and its board of directors agree on specific risk exposure limits. Expected and Unexpected Loss LO 1.4: Distinguish between expected loss and unexpected loss, and provide examples of each. Expected loss considers how much an entity expects to lose in the normal course of business. It can often be computed in advance (and provided for) with relative ease because of the certainty involved.
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