What does VaR (Value at Risk) measure?

Value at Risk (VaR) is a statistical measure used to assess the level of financial risk within a firm or portfolio. Specifically, it estimates the maximum loss that an investment could face over a specified time period, given a certain confidence level. For example, a VaR of $1 million at a 95% confidence level over one day implies that there is a 95% chance that the firm or portfolio will not lose more than $1 million in that day.

This measure is particularly valuable in risk management, as it provides a clear and quantifiable metric to help firms understand and manage their exposure to potential losses. By using VaR, firms can make informed decisions about risk-bearing, capital allocation, and hedging strategies to mitigate those risks.

Other options do not accurately describe VaR’s purpose. For instance, VaR does not measure potential profit or the future growth of market trends, nor does it directly measure the effectiveness of risk management strategies. Instead, it focuses specifically on quantifying potential losses, thereby providing insights into overall risk levels.