Calculating VaR Using Historical
Simulation
PRM EXAM, PRM EXAM III, RISK MANAGEMENT
This lesson is part 4 of 7 in the course Value at Risk
The fundamental assumption of the Historical Simulations methodology is that
you base your results on the past performance of your portfolio and make the
assumption that the past is a good indicator of the near-future.
The below algorithm illustrates the straightforwardness of this methodology. It
is called Full Valuation because we will re-price the asset or the portfolio after
every run. This differs from a Local Valuation method in which we only use the
information about the initial price and the exposure at the origin to deduce
VaR.
Step 1 – Calculate the returns (or price
changes) of all the assets in the portfolio
between each time interval.
The first step lies in setting the time interval and then calculating the returns of
each asset between two successive periods of time.
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Generally, we use a daily horizon to calculate the returns, but we could use
monthly returns if we were to compute the VaR of a portfolio invested in
alternative investments (Hedge Funds, Private Equity, Venture Capital and
Real Estate) where the reporting period is either monthly or quarterly.
Historical Simulations VaR requires a long history of returns in order to get a
meaningful VaR. Indeed, computing a VaR on a portfolio of Hedge Funds with
only a year of return history will not provide a good VaR estimate.
Step 2 – Apply the price changes
calculated to the current mark-to-market
value of the assets and re-value your
portfolio.
Once we have calculated the returns of all the assets from today back to the
first day of the period of time that is being considered – let us assume one
year comprised of 265 days – we now consider that these returns may occur
tomorrow with the same likelihood. For instance, we start by looking at the
returns of every asset yesterday and apply these returns to the value of these
assets today. That gives us new values for all these assets and consequently
a new value of the portfolio.
Then, we go back in time by one more time interval to two days ago. We take
the returns that have been calculated for every asset on that day and assume
that those returns may occur tomorrow with the same likelihood as the returns
that occurred yesterday.
We re-value every asset with these new price changes and then the portfolio
itself. And we continue until we have reached the beginning of the period.
In this example, we will have had 264 simulations.
Step 3 – Sort the series of the portfolio-
simulated P&L from the lowest to the
highest value.
After applying these price changes to the assets 264 times, we end up with
264 simulated values for the portfolio and thus P&Ls.
Since VaR calculates the worst expected loss over a given horizon at a given
confidence level under normal market conditions, we need to sort these 264
values from the lowest to the highest as VaR focuses on the tail of the
distribution.
Step 4 – Read the simulated value that
corresponds to the desired confidence
level.
The last step is to determine the confidence level we are interested in – let us
choose 99% for this example.
One can read the corresponding value in the series of the sorted simulated
P&Ls of the portfolio at the desired confidence level and then take it away
from the mean of the series of simulated P&Ls.
In other words, the VaR at 99% confidence level is the mean of the simulated
P&Ls minus the 1% lowest value in the series of the simulated values.
This can be formulated as follows:
Where:
VaR (1 – ) is the estimated VaR at the confidence level 100 × (1 – )%.
(R) is the mean of the series of simulated returns or P&Ls of the
portfolio
R is the worst return of the series of simulated P&Ls of the portfolio or,
in other words, the return of the series of simulated P&Ls that corresponds to
the level of significance
Need for Interpolation
We may need to proceed to some interpolation since there will be no chance
to get a value at 99% in our example. Indeed, if we use 265 days, each return
calculated at every time interval will have a weight of 1/264 = 0.00379. If we
want to look at the value that has a cumulative weight of 99%, we will see that
there is no value that matches exactly 1% (since we have divided the series
into 264 time intervals and not a multiple of 100). Considering that there is
very little chance that the tail of the empirical distribution is linear, proceeding
to a linear interpolation to get the 99% VaR between the two successive time
intervals that surround the 99th percentile will result in an estimation of the
actual VaR. This would be a pity considering we did all that we could to use
the empirical distribution of returns, wouldn’t it? Nevertheless, even a linear
interpolation may give you a good estimate of your VaR. For those who are
more eager to obtain the exact VaR, the Extreme Value Theory (EVT) could
be the right tool for you. We will explain in another article how to use EVT
when computing VaR. It is rather mathematically demanding and would
require us to spend more time to explain this method.
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