To evaluate portfolio risk, we can make use of different tools in the market to calculate the “worse-case scenario” in trading, such as Value at Risk (VaR).
Understanding Value at Risk (VaR)
Dubbed the “new science of risk management”, Value at Risk (VaR) is a statistic that measures and quantifies the level of financial risk within a firm, a portfolio or a position over a specific time frame. It can be applied to measure the risk exposure of specific positions or whole portfolios.
A VAR statistic has three components: a time period, a confidence level and a loss amount (or loss percentage). Let’s look at an example of using VaR to calculate risks.
BTC/USDT: VaR Calculation
We will focus on the minute closing price of BTC/USDT between Aug 15–21, 2019 on OKEx. This calculation assumes that log-returns are normally distributed.
Step 1: Calculate the minute log-returns
Minute log-returns can be calculated based on the below formula:
We can then divide the log-returns into 27 intervals: (-14%, -13%), (-12%, -11%), …, (12%, 13%), count the number of minute returns for each interval and we get the following histogram:
We can then calculate the average and standard deviation of log-returns based on the formulas:
Step 3: Calculate VaR based on confidence intervals of normal distribution
Assuming the returns are normally distributed, we can see where do the worst 5% and 1% lie on the normal curve. They show trader’s desired confidence, the standard deviation and the average from the below table:
There are two ways to understand the VaR calculation results:
Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involves significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.