Measuring The Potential Loss Amount Due To Market Risk
As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to use Value at Risk. The conventions of using Value at risk is well established and accepted in the short-term risk management practice.
However, it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The Value at Risk of the unchanged portfolio is no longer relevant.
The Variance Covariance and Historical Simulation approach to calculating Value at Risk also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress.
In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.
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