LO 68.7: Explain how VaR can be used in the investment process and the

LO 68.7: Explain how VaR can be used in the investment process and the development of investment guidelines.
Investment Guidelines
VaR can help move away from the ad hoc nature and overemphasis on notionals and sensitivities that characterize the guidelines many managers now use. Clearly, ad hoc procedures will generally be inferior to formal guidelines using established principles. Also, limits on notionals and sensitivities have proven insufficient when leverage and positions in derivatives exist. The limits do not account for variations in risk nor correlations. VaR limits include all of these factors.
The problem with controlling positions and not risk is that there are many rules and restrictions, which in the end may not achieve the main goal. There is no measure of the possible losses that can occur in a given time perioda good quantity to identify in order to know how much capital to have on hand to meet liquidity needs. Furthermore, simple restrictions on certain positions can be easily evaded with the many instruments that are now available. As a wider range of products develop, obviously, the traditional and cumbersome position-by-position guidelines will become even less effective.
Investment Process
VaR can help in the first step of the investment process, which is the strategic asset- allocation decision. Since this step usually uses mean-variance analysis, as does the most basic VaR measures, VaR can help in the portfolio allocation process. Furthermore, VaR can
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Topic 68 Cross Reference to GARP Assigned Reading – Jorion, Chapter 17
measure specific changes in risk that can result as managers subjectively adjust the weights from those recommended by pure quantitative analysis.
VaR is also useful at the trading level. A trader usually focuses on the return and stand-alone risk of a proposed position. The trader may have some idea of how the risk of the position will affect the overall portfolio, but an adequate risk management system that uses VaR can give a specific estimate of the change in risk. In fact, the risk management system should stand ready to automatically calculate the marginal VaR of each existing position and proposed position. When the trader has the choice between adding one of two positions with similar return characteristics, the trader would choose the one with the lower marginal VaR. VaR methodology can help make choices between different assets too. The optimal portfolio will be the one that has the excess-return-to-marginal VaR ratios equal for all asset types, as seen in the previous topic. Thus, when a trader is searching for the next best investment, the trader will look at securities in the asset classes that currently have the higher returns-to-marginal-VaR ratios.
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