Question

Suppose a company has a portfolio consisting of positions in stocks, bonds, currencies, and commodities. Assume that there are no derivative financial products in the portfolio. Explain the assumptions under which the models operate to calculate the following VaR:

-Historical simulation.

-Variances and covariances.

Answer 1

A) Historical simulation

:- Under Historical simulation, it is assumed that you base your result on the past result on the basis of the assumption that past results are a good indicator of future results.

This is the main assumption of historical simulation, which relies only on past data, because it is believed to provide correct results.

B) Variance and Co-variance

:- i) It should be normally distributed

ii) All single period assumptions hold for multiple period

iii) Non negativity :- Financial assets with limited liability cannot attend negative value

iv) Stationary :- A 1% fluctuation in return is equally likely to occur at any point in time.

v) Day to day fluctuation in return is independent.

These are the assumptions based on which VAR is calculated.