The Best of Both Worlds: A Hybrid Approach to Calculating Value at Risk
12 Pages Posted: 7 Jan 1998
Date Written: November 1997
The hybrid approach combines the two most popular approach to VaR estimation: RiskMetrics and Historical Simulation. It estimates the VaR of a portfolio by applying exponentially declining weights to past returns and then finding the appropriate percentile of this time-weighted empirical distribution. This new approach is very simple to implement. Empirical tests show a significant improvement in the precision of VaR forecasts using the hybrid approach relative to RiskMetrics and Historical Simulation. It is especially appropriate for calculating the VaR of fat-tailed and highly skewed data, with rapidly changing moments. As an aside, we also introduce a new method for testing the perfomance of various VaR forecasts.
JEL Classification: G10,C14
Suggested Citation: Suggested Citation