A value at risk (VaR) that measures the amount of loss a diversified portfolio stands to make under certain conditions (such as confidence level). It takes into account the portfolio effect, where adding more components is assumed to lower the risk of the portfolio due to diversification. The lower risk implies a lower VaR.
This type of VaR considers the reciprocal (correlation) and collective effect of diversification on a portfolio’s components. It uses the portfolio’s standard deviation- which is expected to be less than the weighted average of the individual standard deviation of the components unless the returns of such components are positively correlated.
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