Title: What's the difference between a confidence level and a confidence interval in Value at Risk (VaR)?
Headings: Confidence Level and Confidence Interval in Value at Risk (VaR)
Confidence Level and Confidence Interval in Value at Risk (VaR)
Key Takeaways
Value at Risk (VaR)
Confidence Level
Confidence Interval
VaR Portfolio Comparison

Content: The confidence level reflects the level of probability (expressed as a percentage) that the confidence interval would contain the population parameter. Value at Risk (VaR)
VaR is a useful statistic because it helps financial institutions determine the level of cash reserves they need to cover potential portfolio losses. Risk managers traditionally use volatility as a statistical measurement for risk. However, investment and commercial banks frequently use VaR to determine cumulative risks from highly correlated positions held by different departments within the institution. The VaR analysis helps the institution estimate with a high confidence level the maximum amount or percentage that could potentially be lost on an investment over a given time. With VaR modeling, managers can identify investments that have higher-than-acceptable risks, allowing them to reduce or exit positions if needed. One criticism of VaR and other risk assessment metrics is their potential for understating risks and their inability to account for black swan events. Confidence Level
The confidence level determines how sure a risk manager can be when they are calculating the VaR. The confidence level is expressed as a percentage, and it indicates how often the VaR falls within the confidence interval. If a risk manager has a 95% confidence level, it indicates he can be 95% certain that the VaR will fall within the confidence interval. For example, assume that a risk manager determines the 5% one-day VaR to be $1 million.