What does Value at Risk (VaR) measure?

Value at Risk (VaR) is a widely used risk management tool that quantifies the potential loss in value of a portfolio over a defined period for a given confidence interval. It estimates the maximum expected loss that could occur under normal market conditions, thereby providing a clear measure of risk. By establishing a threshold for loss, VaR allows investors and risk managers to understand the worst-case scenario they might face, based on historical data and statistical methods.

For example, if a portfolio has a 1-day VaR of $1 million at a 95% confidence level, this means there is only a 5% chance that the portfolio will lose more than $1 million in a single day. This measure helps in making informed decisions about risk tolerance and capital allocation.

The other options do not accurately reflect what VaR represents. It does not measure upper limits or probabilities of earning specific returns, nor does it quantify fixed costs of risk management. Instead, it specifically focuses on potential losses, thereby providing critical insight into the risk exposure of a portfolio.