The Role of VaR in Enterprise Risk Management: Calculating Value at Risk for Portfolios Held by the Vane Mallory Investment Bank

ALLISSA A. LEE

Assistant Professor of Finance, Georgia Southern University

BETTY J. SIMKINS

Williams Companies Chair of Business and Professor of Finance, Oklahoma State University

You have to risk going too far to discover just how far you can really go.

– Jim Rohn, adapted from T. S. Eliot

Vane Mallory is a large investment bank headquartered in New York. The firm is multifaceted, conducting normal investment banking activities such as underwriting and providing advising and brokerage services to its clients, but also trading on its own account through its trading desk.

You are a senior risk analyst at Vane Mallory investment bank. This is a new position for you and part of your responsibilities includes providing the value at risk (VaR) estimates to the chief risk officer (CRO) of the company, Christian Cross. You are responsible for reporting on two different portfolios:

1. A commodity portfolio that contains energy commodity assets.

2. An equity portfolio that contains stocks of firms based in the United States.

In your previous positions, you were not responsible for this calculation, and it is a relatively foreign concept to you. Accordingly, your boss, the chief risk officer, has given you a few days to acquaint yourself with the idea of VaR so you are prepared to calculate it accurately and efficiently. You did some research and talked to some of your colleagues, and found out quite a bit about VaR. A summary of your findings is included next.

RISK AND VALUE AT RISK OVERVIEW

There are many definitions of risk, but most relate to the possibility of an unexpected outcome. Risk is an inherent part of life for individuals, businesses, and corporations alike. Investment banks are no different, especially given the degree of innovation they have undertaken through the years. As regulations and markets change, profits can potentially decline. Consequently, other avenues must be discovered or created from which revenue can be generated. This process of financial innovation is fraught with risk. From the creation of mortgage-backed securities (MBSs) and collateralized mortgage obligations (CMOs), investment banks have been at the forefront of financial innovation. There are many types of risk, including market, credit, liquidity, operational, and legal risk.

There are various ways to measure risk. Risk is commonly thought of as volatility, which is measured by standard deviation. However, standard deviation is unconcerned with the direction of movement. Naturally, investors are not really worried about movement to the upside; it is the downside movement that is important. A measure of risk that focuses on downside movement is VaR. VaR is a key element of a firm's enterprise risk management (ERM) strategy. One aspect of ERM involves the likelihood and magnitude of impact of events or circumstances to the firm's objective, including both risks and opportunities. The concept of VaR encompasses this quite well and is an integral part of risk management.

 
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