CHAPTER 10 - Value at Risk

Abstract

This chapter is a survey of literature on the management, supervision, and measurement of extreme and infrequent risks in finance. Extreme risks are the risks of very large losses per dollar invested. As losses associated to extreme risks occur infrequently, investors tend to become less alert to these risks over time. A series of bank failures, due to mismanaged portfolios of corporate loans, real estate, and complex derivatives, was a painful reminder of the existence of extreme risks. It prompted new regulations and research on new instruments of risk protection. The implementation of the common guidelines for risk supervision was a very ambitious initiative designed to address a variety of risks. These risks can be divided into three categories: market risk, credit risk or risk of default, and liquidity risk or risk of counterparty. In 1995, the governors of Central Banks gathered in Basle (Switzerland) and adopted a mandatory risk measure called the Value at Risk to be calculated by all banks for each line of their balance sheets. Since then, banks have been required to report the Value at Risk to the regulators and update it daily and hold a sufficient amount of capital (the so-called required capital) as a hedge against extreme risks.