Question

Suppose that investors who determine the Spanish German exchange rates only care about the value-of-risk of their holdings of Spanish assets, how would this affect the equation which determines interest rate parity? How might this affect the consequences of monetary policy? [Hint: define Value-At-Risk and explain how this comes into play].

Answer 1

Answer

Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day.

VaR modeling determines the potential for loss in the entity being assessed and the probability of occurrence for the defined loss. One measures VaR by assessing the amount of potential loss, the probability of occurrence for the amount of loss, and the timeframe.

Value At Risk is applicable to stocks, bonds, currencies, derivatives, or any other assets with price. This is why banks and financial institutions like it so much – they can compare profitability and risk of different units and allocate risk based on VAR (this approach is called risk budgeting).