What does VaR modeling aim to determine?

VaR, or Value at Risk, modeling aims to determine the potential for loss and the probability of specific loss amounts within a given portfolio over a defined time frame. This risk management tool assesses the worst expected loss under normal market conditions, at a specific confidence level. For instance, a VaR of $1 million at a 95% confidence level means that there is only a 5% chance that the portfolio will lose more than $1 million in the specified period.

This focus on potential loss quantification provides investors and portfolio managers with critical insights into risk exposure and enables them to make informed decisions about capital allocation and risk management strategies. By understanding the potential losses associated with their investments, they can implement measures to mitigate risks and align their investment strategy with their risk tolerance levels.

In contrast, other options do not align with VaR's purpose. For example, while expected returns and historical performance are valuable for evaluating a portfolio, they do not address the specific risk profile or potential losses explicitly. Similarly, diversification is more about reducing risk rather than quantifying it through modeling.