VAR is a method of assessing risk that uses standard statistical techniques routinely used in other technical fields. Formally, VAR measures the worst expected loss over a given time interval under normal market conditions at a given confidence interval. Based on firm scientific foundations, VAR provides users with a summary measure of market risk. For instance, a bank might say that the daily VAR of it trading portfolio is $35 million at the 99 percent confidence level. This single number summarizes the bank's exposure to market risk as well as the probability of an adverse move. Equally important, it measures risk using the same units as the bank's bottom line. Shareholders and managers can then decide whether they feel comfortable with this level of risk. If the answer is no, the process that led to the computation of VAR can be used to decide where to trim the risk.
The landmark Basle accord of 1988 provided the first step toward tighter risk management. The Basle accord sets minimum capital requirements that must be met by commercial banks to guard against credit risk. This agreement led to a still-evolving framework to impose capital adequacy requirements against market risk. In their latest proposals, dated April 1995, central bankers implicitly recognized that risk management models in use by major banks are far more advanced than anything they could propose. Banks now have the option to use their own VAR risk management model as the basis for required capital ratios. Thus VAR is being officially promoted as sound risk management practice.
