The Hidden Dangers of Historical Simulation

62 Pages Posted: 2 Oct 2001

See all articles by Matt Pritsker

Matt Pritsker

Federal Reserve Bank of Boston

Date Written: July 2001

Abstract

Many large financial institutions compute the Value-at-Risk (VaR) of their trading portfolios using historical simulation based methods, but the methods' properties are not well understood. This paper theoretically and empirically examines the historical simulation method, a variant of historical simulation introduced by Boudoukh, Richardson and Whitelaw (1998) (BRW), and the Filtered Historical Simulation method (FHS) of Barone-Adesi, Giannopoulos, and Vosper (1999). The Historical Simulation and BRW methods are both under-responsive to changes in conditional risk; and respond to changes in risk in an asymmetric fashion: measured risk increases when the portfolio experiences large losses, but not when it earns large gains. The FHS method appears promising, but requires additional refinement to account for time-varying correlations; and to choose the appropriate length of historical sample period. Preliminary analysis suggests that 2 years of daily data may not contain enough extreme outliers to accurately compute 1% VaR at a 10-day horizon using the FHS method.

Keywords: Risk measurement, value at risk, GARCH

JEL Classification: G10, G18, G20, G28

Suggested Citation

Pritsker, Matthew G., The Hidden Dangers of Historical Simulation (July 2001). FEDS Discussion Paper No. 2001-27. Available at SSRN: https://ssrn.com/abstract=278438 or http://dx.doi.org/10.2139/ssrn.278438

Matthew G. Pritsker (Contact Author)

Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States
617-973-3191 (Phone)

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