VaR (Value at Risk)

Value at Risk have several limitations as a risk measurement tool.

(Question)
The least appropriate limitation of value at risk (VaR) as a risk measurement tool for hedge fund is that:

A. VaR does not provide a left tail risk value.
B. hedge funds often use derivatives, causing their return distributions to be skewed.
C. VaR provides no information on the magnitude of loss beyond the minimum loss.


Answer: A

VaR as a measure of risk in hedge funds has several limitations. VaR, for example, assumes a normal distribution of returns. Therefore, it is not useful for measuring risk in strategies that are negatively skewed or using derivatives, which typically have non-normal returns distributions (think of options, for example). VaR also only indicates the minimum loss at a given level of significance but gives an analyst no information on potential losses beyond this minimum amount.

By definition, VaR gives information on the left tail risk value, for a given probability of occurrence and the time interval.

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• VaR is an ineffective statistical measure of risk when a hedge fund has
• high turnover
• frequent changes in its strategy
• If VaR solely utilizes historical data as inputs, it does not provide a reliable estimate of future risk.