Value at Risk and Beta

Professor Grace recently gave us a practice exam question, dealing with two firms with varying values for their value at risk, and their Beta.

Firm 1 had a Beta=1, and VaR of $2 billion
Firm 2 had a Beta=2 and VaR of $2 million

As discussed in class, these firms are both risky, as seen by these two different risk measures. Like Professor Grace taught us in class, a higher Beta, like that seen in Firm 2, shows that the firm is much more susceptible to changes in the market, making it quite risky. However, Firm 1 has a HUGE VaR of $2 billion, showing that it has a great deal of money on the line to lose.

The question got me thinking about which of these risk measures is actually better to look at, and is a better estimate of the true risk at hand.

I found a presentation by Oklahoma State University, which further expands upon ideas about Beta and VaR that we discussed in class. The expanded information in this presentation helped me further analyze the benefits of each of these risk management techniques, and try to figure out which one I feel is most beneficial.

Like we learned in class, beta shows the fluctuations of the firm (stock) in comparison to market changes. Beta=1 moves exactly with the market, Beta<1>1 is more sensitive to changes than the market. After some more research about beta, I determined that it seems to be a good determiner of just systematic/non-diversifiable risk, but not any other type of risk (diversifiable).

Therefore, it seems to me that VaR is a much better determination of overall risk. VaR gives an estimate of the worst possible loss an investment could realize over a given time period, under normal market conditions. To me, there seem to be many more advantages of using VaR than Beta. For example, the best thing about VaR seems to be that it gives a measure of total risk (diversifiable and non-diversifiable risk), that Beta is unable to analyze. Also, VaR is an easier number to explain to clients trying to understand the risks they face, since it translates portfolio volatility into a clear dollar value. Whereas, Beta would be much more difficult to explain to the clients. Another advantage of VaR is that it can measure the risk of many types of financial securities (stocks, bonds, foreign exchange, derivatives such as futures, forwards, options, etc.). And lastly, VaR is useful for comparing a portfolio with the market portfolio (S&P500).

From all these different qualities, personally I feel that VaR is a better risk measure than Beta. It seems that it has many advantages over Beta. Though I do agree that in the above problem, both firms are definitely risky, I would argue that Firm 1 is riskier due to its very high VaR, and to all the information that comes along with knowing this value.

Oklahoma State University Presentation on Beta and VaR