1. Separate the portfolio in a long side and a short side.

2. Calculate the return series for the long side and the short side.
3. Use the return series to calculate the correlation and variances for the long and short sides
4. Use the results in (3) to calculate the VaR.

The modified approach can be used where, due to the nature of the institutional strategy, a
number of positions would net close to zero on a portfolio basis and also where the set of
securities employed is so large that a variance – covariance approach would have significant
resource/time requirements.

Historical Simulation Method for Value at Risk

(VaR)
This approach requires fewer statistical assumptions for underlying market factors. It applies the
historical (100 days) changes in price levels to current market prices in order to generate a
hypothetical data set. The data set is then ordered by the size of gains/losses. Value at Risk (VaR)
is the value that is equaled or exceeded the required percentage of times (1, 5, 10).

Historical simulation is a non-parametric approach of estimating VaR, i.e. the returns are not
subjected to any functional distribution. VaR is estimated directly from the data without deriving
parameters or making assumptions about the entire distribution of the data. This methodology is
based on the premise that the pattern of historical returns is indicative of future returns.

Monte Carlo Simulation for calculating Value at

Risk (VaR)
The approach is similar to the Historical simulation method described above except for one big
difference. The hypothetical data set used is generated by a statistical distribution rather than
historical price levels. The assumption is that the selected distribution captures or reasonably
approximates price behavior of the modeled securities.

A Monte Carlo simulator uses random numbers to simulate the real world. A Monte Carlo VaR
model using the following sequence of steps

1. Generate randomly simulated prices

2. Calculate daily return series
3. Repeat the steps in the historical simulation method described below
most robust results are likely to come from the historical simulation approach. This happens
because the approach is not handicapped by the normal distribution assumption. The VCV
approach is the most popular approach but also the one with the most criticism given the
normality assumption.

The Monte Carlo approach appears to be fairly attractive but in most simulators the default
distribution used is also normal – which essentially puts the results in the same category and
range as the VCV approach. The big benefit of the simulation approach is when actual trade price
data is not available and prices and returns need to be derived for market factors. This happens
especially when portfolio positions include exotic OTC derivative contracts.

There are a number of tweaks and hacks for building simulators that use the true
distribution rather than a simulated normal distribution.