Question

The definition and calculation method of variance-covariance, VAR and SD.

Please use your own words to explain,thanks.

Answer 1

VAR represents maximum potential loss in portfolio's value with a given probability over a certain time horizon. Simply speaking it is a number that indicates how much a financial institution can lose with probability (p) over a given time horizon (T).

For example, lets say the 95% daily VAR of your assets is $120, then it means that out of those 100 days there would
be 95 days when your daily loss would be less than $120 which is good. However, it also implies that during 5 days you may lose more than $120 daily and there is no limit to this amount.

SD is the standard deviation. It explains how much is the variation in a given metric. For example, let us say in your class the average age of student is 18 years and the standard deviation is 2 yrs. This means that the age of each student hovers around 18 years +- 2yrs for 66% of times, +-4 years for 95 % of times.

Variance -Covariance method is one of the method to calculate VAR. It assumes a normal distribution of the portfolio returns  around the mean of a normal or bell-shaped probability distribution. It uses the mean, standard deviation and normal distribution to quantify VAR.