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VaR seems like such an obviously flawed metric, I am surprised that it seems to be used so much in the private sector.

First, the way it is named and the way it is presented often imply it is the expected value of loss, when in fact it is the upper bound on loss. It seems risk measures should be conservative, and presenting the upper bound, is the opposite of conservative.

More seriously, the fact that VaR is not coherent means that you can't use it to compare two portfolios, or even compare a changing portfolio over time. Doesn't this make value at risk completly useless?

I am just starting out in quant finance, so this is a presumptious question, and I am probably missing something. Thanks for any hlep.

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  • $\begingroup$ VaR is not upper bound on loss, the upper bound is everything in the portfolio. VaR is indeed the expected value of loss. The point is that VaR is simple to calculate and simple to understand. $\endgroup$ – SmallChess Oct 20 '14 at 0:49
  • $\begingroup$ Yes. Banks do use VaR for market-risk management. $\endgroup$ – SmallChess Oct 20 '14 at 0:50
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    $\begingroup$ Conditiona value at risk is an expected value of loss of a quanitle, VaR is the upper bound on that loss. Even on a short horizon how do you tell if risk is higher or lower using VaR? Seems a coherent measure would be far superior. $\endgroup$ – A H Oct 20 '14 at 2:06
  • $\begingroup$ I don't know others, but I calculate both VaR and CVar. To me, I need both or none. $\endgroup$ – SmallChess Oct 20 '14 at 2:08
  • $\begingroup$ There are many types and variations of VaR. Many banks are using them. You could try to find some publications about it. Dig deeper than just standard VaR calculation. $\endgroup$ – Ascorpio Jun 21 '15 at 16:22
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As discussed, banks do use VaR for risk management. They will have something modified for the specific use (i.e. probably not your VaR from a fitted normal distribution), it's likely more sophisticated but the underlying idea is the same. VaR is used for reporting/ceremonial business decisions as much as (or perhaps even more than) it is for trading decisions. I'm outdated on this, but I believe liquidity risk is also becoming an important priority in the Dodd-Frank/Basel III environment, and liquidity adjustments to VaR is probably one of the cool and exciting things to be doing in that space.

On the buy-side, the easiest example that comes to mind is when a trading entity (hedge fund, prop firm etc.) opens a brokerage account. In addition to typical due diligence questions and background about your expected overnight inventory, the brokerage firm will ask you to submit a 'sample portfolio'. That's really just a snapshot of the range of possible position sizes so that they can put that into their risk/compliance department's VaR model and figure out what kind of counterparty risk you'll pose to their overall firm and what kind of position limits to impose on you.

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It is but one of the methods used by risk management to gauge the level of risk undertaken at desk/strategy/account/office/firm etc., levels. Others are risk sensitivities and stress scenarios. All are usually used together to get an overall picture of the risk position and used to make decisions. Even though the absolute VaR value might seem a bit obscure the relative VaR value can be more intuitive and useful to see how risk is changing by the levels given above.

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