• Certified Investment Banking Operations Professional
    4.8 out of 5 by 7600 learners
    8X indsutry demand
  • Post Graduate Program In Capital Markets
    4.7 out of 5 by 807 learners
    3X industry demand
  • Financial Analysis Prodegree
    Co-created with KPMG
    4.7 out of 5 by 3311 learners
    4X indsutry demand
  • Banking And Wealth Management Bootcamp
    4.7 out of 5 by 460 learners
    3X industry demand
  • Post Graduate In New Age Banking
    4.6 out of 5 by 1726 learners
    4X industry demand
  • FinTech Prodegree
    Co-created with Rise Mumbai
    4.6 out of 5 by 1250 learners
    6X industry demand
  • Credit Risk and Underwriting Prodegree
    Co-created with Moody’s Analytics
    4.5 out of 5 by 526 learners
    4X industry demand

If you consider Basel II, there are two ways of calculating Market Risks VAR:
• Historical Simulation Approach
• Model Building Approach

What makes them different?

Historical Simulation approach is most frequently used by organisations. As the name suggests, we consider daily changes in past/historical values to compute the likelihood of the variations in values of current portfolio between given time frame. The other advanced version of this model places more emphasis on recent observations. The key assumption in historical simulation is that the set of possible future outcomes is fully represented by what occurred in a definite historical time frame/window.
On the other side, model-building approach involves assumptions about the joint probability distributions of the returns on the market variables. This model is also known as variance-covariance approach.
This is more apt for portfolios which has short as well as long positions in their bucket. This consists of commodities, bonds, equities, etc. in the portfolio. Here, the mean and standard deviation are computed from the distribution of the underlying assets returns and the correlation between them.
Daily returns on the investments are normally assumed to be multivariate normal which can be the models biggest drawback. Hence, model-building approach makes it easy to calculate Var.
Model Building approach assumes two things:
• The daily change in the value of a portfolio is linearly related to the daily returns from market variables
• The returns from the market variables are normally distributed
Shortcomings of Historical Simulations
Over reliance on past data can fail to serve the purpose as markets change every moment. The momentum can be gradual or sudden, but does not remain static.
Large number of factors like Technology, regulatory changes, economic conditions, seasonal patterns, etc. influence market and in such scenarios manager who are using historical simulation can face unfavourable situation.
Shortcomings of Model Building Approach
Also this approach is much more complex to use when a portfolio comprises of nonlinear products such as options. It is also a grim task to relax the assumption that returns are normal without a significant increase in totalling time.
When to use? Model building vs. Historical simulation.
Depending on the situation, appropriate model should be adopted by the organisation. While both of them have pros and cons, it is important to list down the objectives of risk model before adopting either of them.
Model building approach producer quicker results and can be used in conjunction with volatility and other correlation procedures.
The advantage of the historical simulation approach is that the joint probability distribution of the market variables is determined by historical data. This approach may not be very complicated however, it is little slow for computation. However, the methodology used in historical simulation is in line the risk factor and does not involve any estimation of variances or covariance’s which are statistical parameters.
One should use historical simulation model only when they have data on all risk factors over a justified historical period if they want the model to depict strong representation of the outcome in future.
To know more about model building join Imarticus Learning’s Financial Modeling Certification Courses, which will help you understanding opportunities in the Investment Banking, Private Equity, Budgeting and Financial Control space.


 

Follow Us On Social Media

Twitter


Facebook


LinkedIn


YouTube
For Online Course Enquiries
About Imarticus
Imarticus Learning is India’s leading professional education institute that offers training in Financial Services, Data Analytics & Technology. We’ve successfully transformed careers of over 35,000+ individuals globally through our Certification, Prodegree, and Post Graduate programs offered in association with leading and renowned global organisations in the Financial Services, Data Analytics & Technology domain.
Related course
  • Certification
    Certified Investment Banking Operations Professional
    Course duration(Months)
    2-3
    Upcoming batches
    6
    Organizations enrolled
    20
    4.8 out of 5 by 7600 learners
    8X indsutry demand
    Upcoming Batches
    Date Location Schedule
    7th-Jan THANE Weekday
    14th-Dec DELHI Weekend
    5th-Dec BANGALORE-KORAMANGALA Weekday
    Date Location Schedule
    4th-Jan THANE Weekend
    28th-Dec CHENNAI Weekend
    7th-Dec BANGALORE-KORAMANGALA Weekend
  • Post Graduation
    Post Graduate Program In Capital Markets
    Course duration(months)
    4
    Upcoming batches
    1
    Organizations enrolled
    20
    4.7 out of 5 by 807 learners
    3X industry demand
    Upcoming Batches
    Date Location Schedule
    15-Nov BANGALORE Weekend
    Date Location Schedule
  • Prodegree
    Financial Analysis Prodegree
    Co-created with KPMG
    Course duration(Months)
    3
    Upcoming batches
    1
    Organizations enrolled
    20
    4.7 out of 5 by 3311 learners
    4X indsutry demand
    Upcoming Batches
    Date Location Schedule
    28th-Dec DELHI Weekend
    Date Location Schedule
  • Certification
    Banking And Wealth Management Bootcamp
    Course duration(Months)
    2-3
    Upcoming batches
    1
    Organizations enrolled
    20
    4.7 out of 5 by 460 learners
    3X industry demand
    Upcoming Batches
    Date Location Schedule
    CHENNAI Weekday
    Date Location Schedule
  • Post Graduation
    Post Graduate In New Age Banking
    Course duration(months)
    4
    Upcoming batches
    1
    Organizations enrolled
    20
    4.6 out of 5 by 1726 learners
    4X industry demand
    Upcoming Batches
    Date Location Schedule
    30-Aug CHENNAI Weekday
    Date Location Schedule
  • Prodegree
    FinTech Prodegree
    Co-created with Rise Mumbai
    Course duration(Months)
    4
    Upcoming batches
    1
    Organizations enrolled
    20
    4.6 out of 5 by 1250 learners
    6X industry demand
    Upcoming Batches
    Date Location Schedule
    31-Aug AHMEDABAD Weekday
    Date Location Schedule
  • PRODEGREE
    Credit Risk and Underwriting Prodegree
    Co-created with Moody’s Analytics
    Course duration(Months)
    3
    Upcoming batches
    1
    Organizations enrolled
    20
    4.5 out of 5 by 526 learners
    4X industry demand
    Upcoming Batches
    Date Location Schedule
    none AHMEDABAD Weekday
    Date Location Schedule