“There should be a defined risk management process in place, which is both realistic and is regularly used by the Hedge Fund manager, to manage and monitor risk."

“Hedge Fund managers should identify and understand the sources of risks inherent in their investment styles or processes. ”

AIMA CANADA,
Sound Practices for
Canadian Hedge Fund Managers, 2004

 

Value at Risk

Value at Risk can be an important aid to monitoring and controlling the risk of a portfolio. It provides a consistent and objective measure of market risk, and a full VaR analysis highlights and quantifies the significant sources of risk in a portfolio.

Incremental and contribution VaR can be used to identify the effects of potential portfolio changes on the total VaR. Likewise, using this a manager can quickly determine which changes would be most effective in reducing the portfolio risk.

While VaR is not a panacea for controlling market risk, it is a reliable indicator that should be part of effective portfolio management. It can be likened to the speedometer in a car. On its own a speedometer will not make a car safer. However a good driver will use the speedometer, together with his or her judgment of road conditions, traffic etc. to help maintain an appropriate speed. VaR just tells a manager how fast they are going – it does not tell them what is a safe speed in any particular circumstance. However, many managers who use it regularly find it indispensable.