Suppose a company has a portfolio consisting of positions in...

Name: Problem 7, Chapter 16: Fundamentals of Futures and Options Markets
Uploaded: 2023-06-06T23:37:07-08:00
Duration: 1 min 40 s
Channel: Jennifer Stoner
Description: Suppose a company has a portfolio consisting of positions in stocks, bonds, foreign exchange, and commodities. Assume there are no derivatives. Explain the assumptions underlying (a) the historical simulation and (b) the model-building approach for calculating VaR.

Suppose a company has a portfolio consisting of positions in stocks, bonds, foreign exchange, and commodities. Assume there are no derivatives. Explain the assumptions underlying (a) the historical simulation and (b) the model-building approach for calculating VaR.

Labs

Want to see this concept in action?

NEW

Explore this concept interactively to see how it behaves as you change inputs.

View Labs

Key Concepts

Historical Simulation

This approach assumes that the past behavior of the risk factors is a good proxy for their future dynamics. In other words, the method relies on the idea that historical changes, including returns, volatility, and correlations, remain stable over time. It presumes that extreme events, clustering of volatility, and other market dynamics captured in the historical data will recur in the same way, making the empirical distribution of past returns a valid tool for simulating future portfolio risk.

Model-Building Approach (Parametric Method)

The model-building approach, often referred to as the parametric method, assumes that risk factors follow a specific probability distribution, such as a normal or t-distribution, and that the relationships between these factors are stable over time. This method requires the estimation of parameters (like means, variances, and correlations) from historical data, and it presumes that these estimates accurately capture future risk dynamics. It also relies on the assumption of linearity in risk factor exposures and often uses the variance-covariance structure to aggregate risk, implying that the chosen distribution form is an appropriate representation of the underlying market behavior.

Please give Ace some feedback