Chartered Financial Analyst (CFA) Practice Exam Level 2

What is a primary weakness of Value at Risk (VaR)?

1. It captures both market and credit risk

2. It allows for easy calculation of investment alternatives

3. It provides absolute dollar risk without a risk/return assessment

4. It is applicable for portfolios with few assets only

The correct answer is: It provides absolute dollar risk without a risk/return assessment

The primary weakness of Value at Risk (VaR) is that it provides absolute dollar risk without a risk/return assessment. VaR quantifies the potential loss in value of an asset or portfolio over a defined period for a given confidence interval. While it offers a figure that indicates how much money might be lost, it does not give context regarding the potential return on that investment, nor does it consider the trade-offs between risk and return. This lack of contextual information can be misleading for investors, as they might focus on the risk figure without understanding whether the return they expect justifies the risk they are taking. For example, a high VaR might indicate substantial risk, but if the expected return is also high, the investment might be justified. Conversely, a low expected return with a low VaR suggests that the investment might not be worthwhile. Consequently, investors and risk managers often seek additional metrics or analyses that incorporate risk relative to potential returns, making it necessary to supplement VaR with other measures for comprehensive risk assessment and management.