The VaR or Value at Risk is a way of measuring the risk of an investment which answers the questions how much might I lose, how likely is this and over what timespan.
An investment having a maximum monthly Value at Risk of 10% with 95% statistical confidence will lose 10% or more in a month, 5% of the time ("worst month is 20").
The flip side of this is that this same investment will make more than -10% 95% of the time, that is, 19 out of 20 months.
Risk describes what could happen, in the future
Risk is a forward-looking measure unlike drawdown which describes what did happen, in the past.
Since risk describes what could happen to your money in the future, it's related to a target horizon. At Darwinex this horizon is 1 month.
What is VaR?
Risk at Darwinex is defined as 95% Value at Risk or 95% VaR, a widely used risk measure in finance. It estimates how much an investment might lose with 95% probability, given normal market conditions, in a set time period (which at Darwinex is a month).
In this chart you can see evolution of return of an investment.
What could happen to the return of this investment in the next month? In order to respond to this question, different scenarios get projected taking into account both historical data and thousands of Monte Carlo simulations matching the risk and the style of the investment.
Projections for investments with lower volatility will present a lower volatility than projections for investments with higher volatility which will result in more dispersed scenarios.
These return projections get then plotted on a distribution graph.
95% VaR will be situated at the 95% percentile of the distribution graph.
An investment having a monthly Value at Risk of 10%, will lose 10% or more in a month, 5% of the time ("worst month is 20"). The flip side of this is that this same investment will make more than -10% 95% of the time, that is, 19 out of 20 months.
It is impossible to have 100% accuracy when it comes to making predictions about the future. Therefore, it's common to work with confidence intervals of 90%, 95% or even 99%. The higher the confidence interval is, the more constrained the risk will be.
95% VaR works with a confidence interval of 95%, therefore the probability of not getting it right is 5%, in other words, 1 in every 20 times.
What characteristics of an investment affect risk?
- Frequency of trades. All other things being equal, the more trades in an investment, the higher its risk.
- Leverage and duration of trades. All other things being equal, the higher the leverage and the longer the duration of the trades, the higher the risk.
- Market volatility and correlation of assets. The higher the volatility and the correlation of the assets traded, the higher the risk.
Where to check and track risk on the Darwinex platform
- On the DARWIN page. DARWIN assets have a monthly VaR of maximum 6.5%, managed by the risk manager.
- You may also track the risk of the strategy underlying the DARWIN. The monthly target VaR of the strategy underlying the DARWIN asset will most probably be wither lower or higher that the DARWIN's VaR.
Can DARWIN investors take less risk than a maximum 6.5% monthly VaR? Yes, they can do this through diversification. The more they diversify a portfolio among different DARWINs, the less the risk of your portfolio as a whole. Portfolio risk can be seen in the "Investment" section, "Portfolio risk" subsection of the Darwinex platform.
In the "Risk Measurement at Darwinex" tutorial series we introduce concepts of risk and how it’s measured at Darwinex vs. industry.