Properties of the value at risk estimate using the historical simulation methodology

Abstract

In its most general form, risk can he defined as the possibility an outcome will differ from expectations. This project is concerned with the quantification of market risk which results from the inherent volatility in the prices of financial assets and is of concern to banks and other financial institutions for two principal reasons. Firstly, a large proportion of the assets and liabilities of these types of firms are sensitive to changes in market prices. Secondly, there have been a number of high profile cases of significant losses caused by an inadequate appreciation of market risk. These factors have driven recent advances in quantifying and understanding Market Risk and one increasingly popular technique is known as Value-at-Risk (VaR). Value-at-Risk is a relatively new concept originally developed for exchanges in their settlement operations and has advanced quickly since the late 1980's to become the leading measure of Market Risk in a majority of large banks and trading organizations. JP Morgan produced a standardized framework for the VaR calculation known as RiskMetrics in 1994 prompting an explosion in use by making the methodology and data freely available. A number of regulators, including the Reserve Bank of New Zealand, have advocated VaR as an appropriate risk measure. A principle advantage of a VaR methodology lies in its simplicity. VaR is capable of providing a single number to express the market risk of a portfolio of financial instruments, a property that makes communication of such a complex exposure relatively simple. However, the greatest benefit of the technique lies in the structured analysis of exposures. It is this process of generating the VaR that delivers the benefit to an organization.