How Does a Portfolio’s “Value at Risk” (VaR) Calculation Often Underestimate Tail Risk?
VaR is a statistical measure of the maximum expected loss over a set time horizon at a given confidence level (e.g. 99%).
It often underestimates tail risk because it typically relies on the assumption of a normal distribution, which has thin tails. Since financial returns, especially crypto, have fat tails (high kurtosis), VaR models fail to capture the true probability and magnitude of extreme, low-probability losses.
Glossar
VaR
Measurement ⎊ Value at Risk, within cryptocurrency derivatives, quantifies potential losses in a portfolio over a defined time horizon and confidence level, representing a crucial risk management tool for volatile digital assets.
Maximum Expected Loss
Quantification ⎊ Maximum Expected Loss, within cryptocurrency derivatives, represents a probabilistic estimate of potential loss on a portfolio or position, calculated by weighting possible loss magnitudes by their respective probabilities of occurrence.
Tail Risk
Exposure ⎊ Within cryptocurrency derivatives and options trading, exposure to tail risk signifies the potential for substantial losses arising from events lying outside the typical range of historical outcomes.