Value at Risk methodology comprises the dollar quantification of market value exposure to a specified level of risk in a bank’s trading book to the risk factors associated with each book, with aggregation across books via a correlation matrix to provide a total exposure number. This provides a single metric of the level of exposure of a set of instruments or deals to changes in the values of the market factors that influence their values.
Typical at-risk exposures are defined in terms of the 95th percentile of risk factor value change over 15 day holding period. This period aligns with the time to close out an excessive or undesirable position. Calculation of the risk factor and aggregate VaRs requires knowledge of the volatility of risk factor value changes and the correlation between risk factor movements.
This is crucial for financial institutions, especially banks, in the process of managing the balance sheet. Derivatives are often used as the means to hedge the risk associated with some of the other assets being held.