Quantitative Risk Assessment Tools

There are a number of different quantitative risk assessment tools based on statistical techniques that are available :

Value at Risk (VaR)

Value at Risk (VaR) measures the potential loss in value of a risky asset or event over a defined period for a given confidence interval. It is based on the assumption that the possible outcome of the event is represented by a normal distribution (bell curve). With a normal distribution, we know that:

95% of the results will lie within 1.96 standard deviations of the mean, and that 99% of the results will lie within 2.57 standard deviations of the mean. Using this information, we can predict what the range of results will be with a measured level of confidence.

Value at Risk is a tool for risk assessment to measure risk exposure

Value at Risk is a statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame.

Value at Risk answers the question what is the most I can lose on this investment?

While Value at Risk can be used by any entity to measure its risk exposure; it is used most often by commercial and investment banks to capture the potential loss in value of their traded portfolios from adverse market movements over a specified period; this can then be compared to their available capital and cash reserves to ensure that the losses can be covered without putting the firms at risk

Value at Risk (VAR) Model

Another tool that may be used to assess the risk of a portfolio is called the Value-at-Risk (VAR) Model.(VAR) uses historical price or return distributions to provide a probability statement about the maximum loss that could occur in a portfolio over a specified period of time as a result of changes in market factors. (VAR) does not provide information about how much could be lost in the portfolio over a given period of time but rather provides a worst case scenario, and an estimation of how often that worst case scenario will occur (called a confidence interval)

For example, if a given security has a daily(VAR) of $1 million at the 99% confidence level, this means that on average, the one-day loss on that security will be higher than $1million is only one day out of every 100 trading days (1% of the time)

When used to assess the risk of a portfolio, (VAR) allows for diversification in the portfolio and, if two risks offset one another, it provides a decreased assessment of the overall risk, and vice versa.

(VAR) provides a single number that is related to the maximum loss that could occur, at a given confidence level.

Cash Flow at Risk

Cash Flow at Risk is similar to VaR, but provides a different measure. As the name implies, it measures the likelihood that cash flows will drop by more than a certain amount. Again, this is done using the measures of a normal distribution.

Earnings at Risk

Earnings at Risk measures the confidence interval for the fall in Earnings during the specific period.

Earnings Distributions

Earnings Distributions is a graphical representation of the probability of a level of return.

Earnings per Share Distributions

Earnings per Share Distributions is a graphical representation of the probability of the amount of earnings per share (EPS) and the likelihood of each level occurring.

Benchmarking

Benchmarking compares the company’s risk profile and the impact of potential risks with those
of similar companies.