Limitation of Value at Risk in Portfolio Management

Medium Risk Management Applications Value At Risk

In recent years, a financial manager at a large investment firm implemented a Value at Risk (VaR) model to assess potential losses in the portfolio under normal market conditions. During a specific month, the VaR was reported as $5 million at a 95% confidence level. This indicates that there is a 95% certainty that the portfolio will not lose more than $5 million in value over the given time frame. However, the manager also noted that extreme market events, which are not adequately captured by the VaR model, could lead to significantly more substantial losses.

Which of the following statements best explains a limitation of the VaR measure used in this scenario?

VaR does not account for changes in market conditions that may affect the future volatility of the portfolio.

VaR tends to overstate potential losses during periods of low market volatility.

VaR can indicate that there will be no losses when, in fact, extreme losses could occur.

Hint

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