VALUE AT RISK

Value at risk (VaR) is described as "a technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities" (Investopedia).

Value at risk is commonly used by banks, security firms and companies that are involved in trading energy and other commodities. It is able to measure risk while it happens and is an important consideration when firms make trading or hedging decisions.

There was a very recent article in the New York Times, titled "Risk Mismanagement" which explained their thoughts on how VaR played a major role in the recent financial crisis of 2007-2008. In the article they interviewed many risk managers and determined that though VaR was helpful for risk experts, it created a problem by giving false security to bank executives and regulators. The article described VaR as "an air bag that works all the time, except when you have a car accident." They explain that though VaR is a powerful and helpful tool, and can cause great problems when it is not used correctly.

They explained in the article that VaR...

• Led to excessive risk-taking and leverage at financial institutions
• Focused on the manageable risks near the center of the distribution and ignored the tails
• Created an incentive to take “excessive but remote risks”
• Was “potentially catastrophic when its use creates a false sense of security among senior executives and watchdogs”

(Wikipedia)

So I guess the lesson to take from this is that though VaR can be a great tool for risk management, it is a tool that needs to be used carefully and wisely so that it does not create excessive risks for companies.