Which of the following decisions need to be made as part of laying down a system for calculating VaR:

Which of the following decisions need to be made as part of laying down a system for calculating VaR:

I. The confidence level and horizon

II. Whether portfolio valuation is based upon a delta-gamma approximation or a full revaluation

III. Whether the VaR is to be disclosed in the quarterly financial statements

IV. Whether a 10 day VaR will be calculated based on 10-day return periods, or for 1-day and scaled to 10 days
A . I and III
B . II and IV
C . I, II and IV
D . All of the above

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Answer: C

Explanation:

While conceptually VaR is a fairly straightforward concept, a number of decisions need to be made to select between the different choices available for the exact mechanism to be used for the calculations.

The Basel framework requires banks to estimate VaR at the 99% confidence level over a 10 day horizon. Yet this is a decision that needs to be explicitly made and documented. Therefore ‘I’ is a correct choice.

At various stages of the calculations, portfolio values need to be determined. The valuation can be done using a ‘full valuation’, where each position is explicitly valued; or the portfolio(s) can be reduced to a handful of risk factors, and risk sensitivities such as delta, gamma, convexity etc be used to value the portfolio. The decision between the two approaches is generally based on computational efficiency, complexity of the portfolio, and the degree of exactness desired. ‘II’ therefore is one of the decisions that needs to be made.

The decision as to disclosing the VaR in financial filings comes after the VaR has been calculated, and is unrelated to the VaR calculation system a bank needs to set up. ‘III’ is therefore not a correct answer.

Though the Basel framework requires a 10-day VaR to be calculated, it also allows the calculation of the 1-day VaR and and scaling it to 10 days using the square root of time rule. The bank needs to decide whether it wishes to scale the VaR based on a 1-day VaR number, or compute VaR for a 10 day period to begin with. ‘IV’ therefore is a decision to be made for setting up the VaR system.