What does Value at Risk (VaR) quantify in investment portfolios?

Value at Risk (VaR) is a crucial risk management tool that quantifies the maximum potential loss an investment portfolio could face over a specified time period, given normal market conditions and a certain confidence level. It provides investors and portfolio managers with a clear numerical figure that indicates how much they can expect to lose, but not exceed, with a certain level of certainty, typically expressed as a percentage.

For example, if a portfolio's VaR is stated as $1 million at a 95% confidence level over one day, it implies that there is a 95% probability that the portfolio will not lose more than $1 million in a day. Thus, it effectively encapsulates the concept of potential risk within a defined timeframe, guiding decision-making regarding risk tolerance and the necessary capital reserves or hedging strategies.

The other options do not accurately describe the fundamental purpose of VaR. While expected return and asset value are essential factors in investment analysis, they do not reflect the specific risk quantification that VaR is designed to provide. Similarly, while diversification can affect risk, it is not directly measured by VaR, which focuses solely on the potential maximum loss.