Imagine living your best life, enjoying the fruits of your wise investments in the stock market. You have followed the golden rule of diversification to spread the risk, and your investment portfolio is thriving. Life is good! But here is a question for you as an investor: Can you predict how much you might lose if an unexpected storm hits the global markets, causing chaos and panic overnight? Chances are, your answer would be a hesitant ‘no’.
However, if you were to ask the same question to a financial institution like a fund house, bank, or investment firm, they would likely have a precise answer for you. Why? Because they manage your money, and they understand exactly how much risk they are taking and what potential losses might occur if their investment strategies go wrong or uncertainty hits them. In other words, they are always calculating the value of the risk they are exposed to.
So, how do they do it? Well, they use a financial tool called ‘Value at Risk’ or VaR.
What is Value at Risk? Value at Risk, or VaR, is a tool that helps investors, companies, and fund managers figure out how much money they might lose in the worst-case scenario.Now, why would you want to use VaR? Well, there are a few reasons. First, it helps you understand the absolute worst outcome for your investment. Second, it helps you check if you have enough money to cover those potential losses.
If not, it is like a warning that you might be taking too much risk. Hence, you might want to diversify or liquidate your investments before it’s too late.
Calculating the Value at Risk
When calculating the Value at Risk of an investment, we ask ourselves: “What is the maximum amount I could lose on my investment, given a certain level of confidence, over a specific period?” We know we just heard some new terms, but let’s break them down.
Time Horizon The time horizon is looking into the future. So, if you have invested Rs 1,000 in a stock and want to know how much you could lose in the next day or week. That is your time horizon. It is how far into the future you are trying to predict.
Confidence Level The confidence level is how sure you want to be. It is usually expressed as a percentage, like 95% or 99%. Let’s say you choose a 95% confidence level. This means you want to be 95% sure your prediction is correct. Asset or Portfolio VaR can be applied to a single asset, a portfolio of assets, or even an entire business operation. The choice depends on what you want to assess.
Now, let’s dive into the methods for calculating Value at Risk (VaR).
Historical Method This method is like looking at the past to predict the future. Let’s say you have Rs 1,000 invested in a stock. You want to know how much you could lose in the next day (your time horizon) with 95% confidence (your confidence level).
As per the historical method, you will look at the past 100 days, and the worst loss was Rs 50 on one of those days. So, your VaR for one day at a 95% confidence level would be Rs 50.
Based on historical data, you are 95% sure you won’t lose more than Rs 50 in one day.
Variance-Covariance Method In the variance-covariance method, the volatility of the stock plays an important role. Let’s understand how.
So, in this method, we use math and statistics to make future predictions. You have to figure out two things: the average (mean) return of an investment and the stock’s volatility (standard deviation). For example, suppose a stock typically goes up by 5% on average and has a volatility of 10%. In that case, you can use these numbers to estimate how much you might lose over a certain period if your investment amount is Rs 1,000.
Formula for calculating VaR = [Average Return – (Z-score * Volatility)] * Investment Amount
Note that the Z-score is a term that corresponds to your chosen level of confidence. For a 95% confidence level, the Z-score is approximately 1.96.
So, if we plug in the values from our previous example:
Average Return = 5%
Z-score for 95% confidence = 1.96
Volatility = 10%
Investment = Rs 1,000
If you put in the numbers, you would get a VaR of −146. This means you might expect to lose around Rs 146 with a 95% confidence level if your investment is 10% volatile over the specified time frame.
But, if the volatility becomes 30%, the loss you might expect increases from Rs 146 to Rs 537. This tells us that the higher the volatility of the asset, the higher the losses you would see.
Now, you don’t need to sit and calculate the VaR of each stock in your Demat account because you can easily access the VaR on NSE and BSE’s websites. Here, VaR is updated six times a day.
For example, the VaR of Reliance Industries on NSE is 8.83%, while for SBI, it is 9.64% (*Data as of 4th September, 2:15 pm). This shows that SBI’s stock is more volatile than Reliance on a specific day.
How Does Value at Risk Play an Important Role in Determining Margins? In the equity segment, every transaction involves a certain level of financial security known as margins. This is collected upfront by the clearing corporation from brokers for the trades they execute. This money ensures that you have the means to cover potential losses from your trade.
Margin requirements typically include VaR (Value at Risk) and ELM (Extreme Loss Margin).
While we have already discussed VaR, let’s delve a bit deeper into ELM.
ELM, or Extreme Loss Margin, is an additional margin complementing VaR. It is designed to provide coverage for potential losses that might exceed what is initially predicted by the VaR models. ELM represents a fixed supplementary margin that is imposed alongside VaR. Both of these margins are calculated based on the value of the trade and are expressed as a percentage of that trade’s total value.
Here is an example: Suppose an investor decides to acquire stocks with a total value of Rs 1 lakh, and the designated VaR and ELM margin for this particular stock is set at 12.50%. In this scenario, a sum of Rs 12,500 is temporarily held as a margin to secure the trade. This ensures sufficient funds are in place to cover potential losses and maintain the financial system’s stability.
To conclude, different firms use VaR in several ways. For example, VaR is used by clearing corporations to understand the margin they must collect, while fund managers use VaR to analyse and manage their total level of risk exposure. Investors can also use the VaR data while making an investment decision.
*The companies mentioned are for information purposes only. This is not an investment advice.
(The author is Vice President of Research, TejiMandi)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
NEW YORK (AP) — Shares of Tesla soared Wednesday as investors bet that the electric vehicle maker and its CEO Elon Musk will benefit from Donald Trump’s return to the White House.
Tesla stands to make significant gains under a Trump administration with the threat of diminished subsidies for alternative energy and electric vehicles doing the most harm to smaller competitors. Trump’s plans for extensive tariffs on Chinese imports make it less likely that Chinese EVs will be sold in bulk in the U.S. anytime soon.
“Tesla has the scale and scope that is unmatched,” said Wedbush analyst Dan Ives, in a note to investors. “This dynamic could give Musk and Tesla a clear competitive advantage in a non-EV subsidy environment, coupled by likely higher China tariffs that would continue to push away cheaper Chinese EV players.”
Tesla shares jumped 14.8% Wednesday while shares of rival electric vehicle makers tumbled. Nio, based in Shanghai, fell 5.3%. Shares of electric truck maker Rivian dropped 8.3% and Lucid Group fell 5.3%.
Tesla dominates sales of electric vehicles in the U.S, with 48.9% in market share through the middle of 2024, according to the U.S. Energy Information Administration.
Subsidies for clean energy are part of the Inflation Reduction Act, signed into law by President Joe Biden in 2022. It included tax credits for manufacturing, along with tax credits for consumers of electric vehicles.
Musk was one of Trump’s biggest donors, spending at least $119 million mobilizing Trump’s supporters to back the Republican nominee. He also pledged to give away $1 million a day to voters signing a petition for his political action committee.
In some ways, it has been a rocky year for Tesla, with sales and profit declining through the first half of the year. Profit did rise 17.3% in the third quarter.
The U.S. opened an investigation into the company’s “Full Self-Driving” system after reports of crashes in low-visibility conditions, including one that killed a pedestrian. The investigation covers roughly 2.4 million Teslas from the 2016 through 2024 model years.
And investors sent company shares tumbling last month after Tesla unveiled its long-awaited robotaxi at a Hollywood studio Thursday night, seeing not much progress at Tesla on autonomous vehicles while other companies have been making notable progress.
TORONTO – Canada’s main stock index was up more than 100 points in late-morning trading, helped by strength in base metal and utility stocks, while U.S. stock markets were mixed.
The S&P/TSX composite index was up 103.40 points at 24,542.48.
In New York, the Dow Jones industrial average was up 192.31 points at 42,932.73. The S&P 500 index was up 7.14 points at 5,822.40, while the Nasdaq composite was down 9.03 points at 18,306.56.
The Canadian dollar traded for 72.61 cents US compared with 72.44 cents US on Tuesday.
The November crude oil contract was down 71 cents at US$69.87 per barrel and the November natural gas contract was down eight cents at US$2.42 per mmBTU.
The December gold contract was up US$7.20 at US$2,686.10 an ounce and the December copper contract was up a penny at US$4.35 a pound.
This report by The Canadian Press was first published Oct. 16, 2024.
TORONTO – Canada’s main stock index was up more than 200 points in late-morning trading, while U.S. stock markets were also headed higher.
The S&P/TSX composite index was up 205.86 points at 24,508.12.
In New York, the Dow Jones industrial average was up 336.62 points at 42,790.74. The S&P 500 index was up 34.19 points at 5,814.24, while the Nasdaq composite was up 60.27 points at 18.342.32.
The Canadian dollar traded for 72.61 cents US compared with 72.71 cents US on Thursday.
The November crude oil contract was down 15 cents at US$75.70 per barrel and the November natural gas contract was down two cents at US$2.65 per mmBTU.
The December gold contract was down US$29.60 at US$2,668.90 an ounce and the December copper contract was up four cents at US$4.47 a pound.
This report by The Canadian Press was first published Oct. 11, 2024.
