Value at Risk(VaR)

Value at Risk(VaR): is a statistical estimate of an upper boundary, within a specified confidence level, of the potential amount a trading position or portfolio could decrease in value during the time needed to close out a position. Specifically, it is a measure of potential loss from an event in a norma, everyday market environment. VaR is denominated in a currency, say taka, where it measures the cance of losing Taka for a movement in interest rates for a given balance sheet scenario. For example, if a bank only has 1 month borrowing to fund 1 year customer lending, an incerase in 1 month rates would result in incremental expense for the bank. VaR is estimated by assuming a 97.5% confidence level for movement in relevant Market Risk Factors.
Let us construct a very simple example to understand the VaR methodology. In the following table a simple hypothetical balance sheet for a bank is shown, where it has BDT 100 1 month borrowing to fund same amount of assets:

Asset 1 month=0 I year=100
Liability : 1 month=100 1 year=0
Mismatch: I month=(100) I year=100

Say the market interest rete for 1 month is 8% and 1 year is 10%. Now, if we need to square the balance sheet gaps, we need to lend in  1 month at 8% and need to borrow in 1 year tenor at 10%. Therefore, the expected Value at Risk to square the position will be:

VaR=100*(8%*30days/360days)-(100*10%*360 days/360 days)=(0.67-10)=9.33

Different organisations use different techniques or formulas for calculating VaR.