What is Value at Risk:
- A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio
- Parametric
- Historical Simulation
- Monte Carlo Simulation (focus)
- based on the concept of taking a current level and simulating returns of the underlying risk factors of a position instrumental model
- Considered the best practice
- More accurate than the parametric method and historical simulation method
What is Parametric Method?
- Follows Mean-Variance approach
- Standard deviation of portfolio return: (equation to the left)
- where σP is the standard deviation of portfolio returns or volatility, w is the vector containing the weights of the different securities in the portfolio, Ω is the covariance matrix
What is the Historical Method?
- Does not depend on any explicit distribution of security returns
- Simulate possible returns on current portfolio using historical returns of constituent assets
- Assume the future would be similar to the past