Which of the following is a limitation of value at risk?

Value at Risk (VaR) is a widely used risk management tool that estimates the potential loss in value of a portfolio under normal market conditions within a specific time frame and for a given confidence interval. The correct option highlights one of the key limitations of VaR: it does not account for extreme market movements, also known as "tail risk."

In financial markets, extreme events can lead to significant losses that exceed the VaR estimate. For instance, during periods of high volatility or market shocks, the actual losses may significantly exceed the predicted VaR, which typically focuses on historical data and assumes that market movements will remain within a certain range. This limitation means that while VaR can provide insights under normal conditions, it can underestimate the risk during extreme market scenarios, potentially leading to inadequate capital reserves or poor risk management decisions.

Understanding this limitation is crucial for financial services auditors as they assess the effectiveness of risk management strategies and tools a financial institution uses. By recognizing that VaR may not capture the full spectrum of risk, auditors can recommend complementing it with other risk assessment techniques that account for extreme scenarios, ensuring a more robust risk management framework.