Final answer:
A 2% VAL at Risk (VAR) means there is a 98% confidence that losses will not exceed 2% of the portfolio's value over a set time period. It is related to the concepts of expected rate of return and risk, with higher VAR indicating a greater potential loss.
Step-by-step explanation:
The question is asking to clarify what a 2% Value at Risk (VAR) implies for a portfolio. VAR is a common measure used in finance to assess the risk of loss on a portfolio. To understand what a 2% VAR means, we can relate it to confidence intervals and expected rates of return in the context of investment risk.
It is important to note that a 2% VAR does not mean there is a 98% confidence that a loss will occur. Rather, it signifies that there is a 98% confidence level that the loss on the portfolio will not exceed 2% of its total value over a given time period. This is inferred from our understanding that a 95% confidence interval for the mean typically extends two standard deviations from the sample mean, both above and below.
For example, if an investment has a 2% VAR, and the portfolio's total value is $100,000, it suggests that with a 98% confidence level, you should not expect to lose more than $2,000 over the specified time period. However, this also means there is a 2% chance that the loss could exceed that 2% threshold.
Understanding the relationship between expected rate of return, risk, and actual rate of return is central to comprehending VAR. The expected rate of return reflects the average return anticipated over a period, while risk quantifies the uncertainty associated with the potential variability in returns. A higher VAR percentage would imply a greater risk since it would indicate a larger potential loss.