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Three Methodologies for Calculating VaR
There are three major methodologies for calculating VaR.
- Parametric
- Monte Carlo
- Historical
Note that the risk of nonlinear instruments (for example, options) is more complex to estimate than the risk of linear instruments (for example, traditional stocks, bonds, swaps, forwards, and futures), which can be approximated with simple formulas.
Financial instruments are nonlinear when their price does not change by a constant amount given a small movement in an underlying reference asset.
Brief Description
Brief description and use of each approach:
| Type | Description | Use |
|---|---|---|
| Parametric | Estimates VaR with equation that specifies parameters (for example, volatility and correlation) as input. | Accurate for traditional assets and linear derivatives, but less accurate for nonlinear derivatives |
| Monte Carlo | Estimates VaR by simulating random scenarios and revaluing instruments in the portfolio | Appropriate for all types of instruments, linear or nonlinear |
| Historical | Estimates VaR by reliving history; we take actual | |
| historical rates and revalue a portfolio for each |
change in the market | Appropriate for all types of instruments, linear or non-linear |
Advantages and Disadvantages
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