Question

Describe 3 pros and 3 cons for each of the Historical, Parametric and Monte Carlo methods of calculating Value at Risk

Answer 1

There are 3 methods to calculate Value at Risk.

1. Historic Method

2. Parametric Method

3. Monte Carlo Method.

Every method has its advantages and disadvantages.

1. Historic Method

Advanatages :

a) It is easy to compute.

b) It can be easily explained to people.

c) There is no need to make distributional assumptions in this model.

Disadvanatages :

a) It works on the assumption that History repeats itself that is the future will be similar to the past.

b) It does not perform what-if analysis of a situation.

c) Sometimes it produces misleading estimates.

2. Parametric Method

Advanatages :

a) It is faster to compute.

b) It is very simple to use.

c) Data for the inputs is very easy to obtain.

Disadvanatages :

a) It assumes that the historical returns and the changes in prices of the assets follow a normal distribution.

b) It is less accurate for non-linear portfolios like options or mortgage-backed securities.

c) Underestimates VaR at high confidence levels and overestimates VaR at low confidence levels.

3. Monte Carlo Simulation Method

Advanatages :

a) It is accurate for non linear instruments unlike other methods.

b) It is not affected as much by extreme events.

c) Can use any statistical distribution to simulate the returns as far as comfortably possible.

Disadvanatages :

a) Time consuming and complicated.

b) Costly to develop a VaR engine.

c) There is always a exposure to huge model risk in determining the likelihood of any given path.