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Topics How To Convert Value At Risk To Different Time

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by David Harper,CFA, FRM (Contact Author | Biography)
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Here we explain how to convert one value at risk (VAR) of one time period into the
FOREX equivalent VAR for a different time period and show you how to use VAR to estimate the
ETFs downside risk of a single stock investment.
Active Trading
Converting One Time Period to Another
Bonds In Part 1, we calculate VAR for the Nasdaq 100 index (ticker: QQQ) and establish that VAR
Economics answers a three-part question: "What is the worst loss that I can expect during a specified
Financial Careers
time period with a certain confidence level?"

Financial Theory Since the time period is a variable, different calculations may specify different time periods -
Fundamental Analysis there is no "correct" time period. Commercial banks, for example, typically calculate a daily
VAR, asking themselves how much they can lose in a day; pension funds, on the other
Insurance
hand, often calculate a monthly VAR.
Options & Futures
Personal Finance To recap briefly, let's look again at our calculations of three VARs in part 1 using three
different methods for the same "QQQ" investment:
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Tutorials * We do not need a standard deviation for neither the historical method (because it just
re-orders returns lowest-to-highest) or the Monte Carlo simulation (because it produces
Ask Us the final results for us). Ask Investopedia
FXtrader A formula timing plan which consists of periodic
Because of the time variable, users of VAR need to know how to convert one time period to
purchases of a fixed dollar amount of an
Simulator another, and they can do so by relying on a classic idea in finance: the standard deviation of
investment company regardless of price is
stock returns tends to increase with the square root of time. If the standard deviation of
known as: (view answer)
Financial Edge daily returns is 2.64% and there are 20 trading days in a month (T = 20), then the monthly
standard deviation is represented by the following:
Stock Ideas Is there a buy-and-hold strategy in forex, or is
the only way to make money by trading? (view
Free Tools answer)

Calculators How do you lose money in the Forex market?

To "scale" the daily standard deviation to a monthly standard deviation, we multiply it not by (view answer)
Free Newsletters 20 but by the square root of 20. Similarly, if we want to scale the daily standard deviation to
an annual standard deviation, we multiply the daily standard deviation by the square root of What are the "browser wars"? (view answer)
250 (assuming 250 trading days in a year). Had we calculated a monthly standard deviation
(which would be done by using month-to-month returns), we could convert to an annual What's the difference between weighted
standard deviation by multiplying the monthly standard deviation by the square root of 12. average accounting and FIFO/LILO accounting
methods? (view answer)
Applying a VAR Method to a Single Stock
Both the historical and Monte Carlo simulation methods have their advocates; but the What effect did the Bankruptcy Abuse
historical method requires crunching historical data, and the Monte Carlo simulation method Prevention and Consumer Protection Act of
is complex. The easiest method is variance-covariance. 2005 have on debtors? (view answer)
Below we incorporate the time-conversion element into the variance-covariance method for
What was Robert Citron's role in Orange
a single stock (or single investment):
County, California's bankruptcy? (view answer)

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How To Convert Value At Risk To Different Time Periods http://www.investopedia.com/articles/04/101304.asp

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Now let's apply these formulas to the QQQ. Recall that the daily standard deviation for the
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QQQ since inception is 2.64%. But we want to calculate a monthly VAR, and assuming 20
trading days in a month, we multiply by the square root of 20: Everyday Fees And How To Avoid Them
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* Important Note: These worst losses (-19.5% and -27.5%) are losses Ads by
below the expected or average return. In this case, we keep it simple by Never Miss A Beat
assuming the daily expected return is zero. We rounded down, so the Get the most up to date
worst loss is also the net loss. breaking new stories as they
happen across the globe...
So, with the variance-covariance method, we can say with 95% confidence that we will not Learn more
lose more than 19.5% in any given month. The QQQ clearly is not the most conservative
investment! You may note, however, that the above result is different from the one we got
under the Monte Carlo simulation, which said our maximum monthly loss would be 15% Create Your Own News!
(under the same 95% confidence level). Newscircles are a quick,
convienient way to create and
Conclusion publish your own customized
Value at risk is a special type of downside risk measure. Rather than produce a single news portals... Learn more
statistic or express absolute certainty, it makes a probabilistic estimate. With a given
confidence level, it asks, "What is our maximum expected loss over a specified time Stay Connected
period?" There are three methods by which VAR can be calculated: the historical simulation, Discover the best free real-time
the variance-covariance method and the Monte Carlo simulation. news, networking and
information portal on the web...
The variance-covariance method is easiest because you need to estimate only two factors: Learn more
average return and standard deviation. However, it assumes returns are well-behaved
according to the symmetrical normal curve and that historical patterns will repeat into the
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future.

The historical simulation improves on the accuracy of the VAR calculation, but requires more
computational data; it also assumes that "past is prologue". The Monte Carlo simulation is
complex, but has the advantage of allowing users to tailor ideas about future patterns that
depart from historical patterns.

To read more on this subject, see Continuously Compound Interest.

by David Harper,CFA, FRM (Contact Author | Biography)

In addition to writing for Investopedia, David Harper, CFA, FRM, is the founder of The
Bionic Turtle, a site that trains professionals in advanced and career-related finance,
including financial certification. David was a founding co-editor of the Investopedia
Advisor, where his original portfolios (core, growth and technology value) led to superior
outperformance (+35% in the first year) with minimal risk and helped to successfully
launch Advisor.

He is the principal of Investor Alternatives, a firm that conducts quantitative research,

consulting (derivatives valuation), litigation support and financial education.

Filed Under: Economics, Financial Theory

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