The hidden dangers of historical simulation

Matthew Pritsker

No 2001-27, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: Many large financial institutions compute the Value-at-Risk (VaR) of their trading portfolios using historical simulation based methods, but the methods' properties are not well understood. This paper theoretically and empirically examines the historical simulation method, a variant of historical simulation introduced by Boudoukh, Richardson and Whitelaw (1998) (BRW), and the Filtered Historical Simulation method (FHS) of Barone-Adesi, Giannopoulos, and Vosper (1999). The Historical Simulation and BRW methods are both under-responsive to changes in conditional risk; and respond to changes in risk in an asymmetric fashion: measured risk increases when the portfolio experiences large losses, but not when it earns large gains. The FHS method appears promising, but requires additional refinement to account for time-varying correlations; and to choose the appropriate length of historical sample period. Preliminary analysis suggests that 2 years of daily data may not contain enough extreme outliers to accurately compute 1% VaR at a 10-day horizon using the FHS method.

Keywords: Risk; Econometric models (search for similar items in EconPapers)
Date: 2001
New Economics Papers: this item is included in nep-cmp
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Citations: View citations in EconPapers (33)

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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2001-27

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