INTRODUCTION TO VALUE AT RISK (VaR) - Wiley …

CHAPTER ONEINTRODUCTION TO VALUE AT RISK (VaR)CHAPTER Economics underlying VaR What is VaR? Calculating The assumptions behind VaR Inputs into VaR Diversification and Factors affecting portfolio Decomposing volatility into systematic and idiosyn-cratic Diversification: Words of caution the case of long-term capital management (LTCM)Risk measurement has preoccupied financial market participantssince the dawn of financial history. However, many past attempts haveproven to be impractically complex. For example, upon its introduc-tion, Harry Markowitz s Nobel prize-winning theory of portfolio riskmeasurement was not adopted in practice because of its onerous , it was Bill Sharpe who, along with others,2madeportfolio theory the standard of financial risk measurement in real worldapplications through the adoption of the simplifying assumption thatall risk could be decomposed into two parts: systematic, market riskand the residual, company-specific or idiosyncratic risk.

INTRODUCTION TO VALUE AT RISK (VaR) 3 Indeed, the VaR tool is complementary to many other internal risk measures – such as RAROC developed by Bankers Trust in the 1970s.6 However, market forces during the late 1990s created conditions that

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