What does Value at Risk (VaR) estimate?

Value at Risk (VaR) is a statistical measurement that estimates the potential loss in value of a portfolio over a specified period for a given confidence interval. It provides a quantitative measure of the risk of loss in financial markets and represents the worst expected loss under normal market conditions over a set time frame, assuming that the market follows a certain statistical distribution. For instance, a VaR of $1 million at a 95% confidence level indicates that there is a 95% probability that the portfolio will not lose more than $1 million over a defined period, such as one day.

This definition focuses specifically on the downside risk, highlighting how much value could be lost in adverse market conditions, making it a critical tool for risk management in finance. It does not provide a measure of the total value of a portfolio, maximum potential gains, or the average returns, all of which pertain to different aspects of financial analysis and do not directly relate to the risk estimation that VaR encompasses.