What does VAR estimate?

Value at Risk (VaR) is a statistical measure used to assess the level of risk associated with an investment portfolio or a firm. Specifically, it estimates the minimum loss that is expected over a specified time period at a certain confidence level. For example, if the VaR for a portfolio is $1 million at a 95% confidence level over one month, it means there is a 95% probability that the portfolio will not lose more than $1 million over that month.

The focus of VaR is on the downside risk, providing investors and risk managers with a quantifiable measure of potential losses they might face. This makes it a critical tool in risk management as it highlights the worst-case scenario for the portfolio at the given probability and time frame. In this context, the other choices do not align with the fundamental purpose of VaR, as it does not estimate total expected returns, maximum potential gains, or average returns, but rather emphasizes the quantification of potential losses within defined criteria.