How do I decide between 95%, 99%, and 99.9% confidence for VaR?

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AcadiFi · Accepted Answer

The confidence level answers 'how often am I willing to breach VaR?' A 95% daily VaR is breached on average 13 times per year; 99% once every 100 trading days; 99.9% roughly once per four years. Trading desks often monitor at 95% because more frequent breaches allow fast model validation through backtesting, while regulators prefer 99% for market risk capital because it captures severe but plausible loss. Economic capital teams set 99.9% because capital must cover solvency at a near-default confidence tied to AA credit ratings. The tradeoff is tail uncertainty: the higher the confidence, the further into the tail you estimate, and the fewer historical observations support the estimate, so parameter risk explodes. A 99.9% one-day VaR based on three years of data has fewer than one genuine extreme observation, meaning the model structure dominates the answer. Choose confidence based on purpose: backtesting-friendly monitoring at 95%, regulatory capital at 99%, solvency-level economic capital at 99.9%. Expected Shortfall, which averages losses beyond the VaR threshold, is less sensitive to the exact confidence level chosen and is why FRTB moved markets to ES at 97.5% — roughly equivalent in capital terms to 99% VaR but with better tail information.

How do I decide between 95%, 99%, and 99.9% confidence for VaR?

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