What is the formula for calculating Value at Risk (VaR) using the stress test methodology?

Value at Risk (VaR) is a statistical measure used to assess the level of financial risk within a firm or portfolio over a specific time period. The stress test methodology for calculating VaR involves evaluating the potential change in value of an asset or portfolio under extreme market conditions.

Using the formula presented in the correct choice, the calculation of VaR incorporates both the percentage of risk (VaR %) and the present value of cash flows (PV(CF)). The rationale behind this methodology is that VaR quantifies the worst expected loss under normal market conditions at a given confidence level, while the present value of cash flows reflects how future cash flows are valued today. By multiplying these two components, the formula effectively estimates the potential loss in value, taking into account the degree of risk expressed as a percentage.

This approach aligns with the objectives of stress testing, expressing how much worse-than-expected outcomes can impact portfolio value under severe market disruptions. Therefore, the formula provides a comprehensive way to assess risks stemming from market volatility and helps in risk management strategies by quantifying potential losses more accurately.

The other options represent different combinations of the elements involved in this calculation but do not accurately describe the relationship necessary to establish VaR using stress testing. They either add,