Module: | MODULE B: RISK MANAGEMENT
Q350: Consider the following statements regarding the Value at Risk (VaR) metric used extensively in market risk measurement:
1. VaR quantifies the absolute maximum possible loss a portfolio can suffer under the most extreme, worst-case catastrophic market scenarios.
2. A 1-day VaR of ₹ 5 Crore at a 99% confidence level implies there is a 1% probability that the portfolio will lose more than ₹ 5 Crore in a single trading day.
3. Under the Basel regulatory capital guidelines, banks are required to calculate VaR at a 99% one-tailed confidence interval.
2. A 1-day VaR of ₹ 5 Crore at a 99% confidence level implies there is a 1% probability that the portfolio will lose more than ₹ 5 Crore in a single trading day.
3. Under the Basel regulatory capital guidelines, banks are required to calculate VaR at a 99% one-tailed confidence interval.
✅ Correct Answer: B
The correct answer is B. Statement 2 is correct: It provides the precise statistical definition of VaR.
A 99% confidence level means we are 99% sure losses will not exceed ₹ 5 Crore; conversely, there is a 1% probability (the tail) that losses will exceed that threshold.
Statement 3 is correct: Basel and RBI market risk frameworks explicitly mandate the use of a 99% one-tailed confidence interval for regulatory VaR calculations.
Statement 1 is radically incorrect: This is the most common misconception about VaR.
VaR does NOT measure the "absolute maximum possible loss" or "worst-case scenario." VaR explicitly ignores what happens in the extreme tail (the worst 1%). To measure catastrophic, worst-case losses, banks must use Expected Shortfall (Tail VaR) or Extreme Stress Testing.
A 99% confidence level means we are 99% sure losses will not exceed ₹ 5 Crore; conversely, there is a 1% probability (the tail) that losses will exceed that threshold.
Statement 3 is correct: Basel and RBI market risk frameworks explicitly mandate the use of a 99% one-tailed confidence interval for regulatory VaR calculations.
Statement 1 is radically incorrect: This is the most common misconception about VaR.
VaR does NOT measure the "absolute maximum possible loss" or "worst-case scenario." VaR explicitly ignores what happens in the extreme tail (the worst 1%). To measure catastrophic, worst-case losses, banks must use Expected Shortfall (Tail VaR) or Extreme Stress Testing.