VaR Methods:

Historical Simulation Approach:

1. Basic approach.
2. Weighted approach.
3. Volatility-adjusted approach (EWMA).
4. GARCH.
Model Building Approach
1. Variance -Covariance Approach.
2. Variance - Covariance (EWMA) Approach.
Monte Carlo Simulation Approach.

Historical Simulation Method for calculating Value at Risk (VaR)

Historical simulation is a relatively simple approach to calculating value
at risk that avoids some of the drawbacks of the Variance covariance
approach. In particular, it avoids the assumption that returns on the
assets in a portfolio are normally distributed.
Instead, it uses actual historical returns on the portfolio assets to
construct a distribution of potential future portfolio profits and losses,
from which the VaR can be read. This approach requires minimal
analytics. All it needs is a sample of the historic returns on the different
instruments in the portfolio whose value at risk we wish to calculate.
1

Calculating VaR Using the Historical Simulation basic Approach

The steps required to calculate VaR using historical simulation are
similar to those for Monte Carlo simulation, but the process is easier.
Rather than generating scenarios based on random draws, the price
scenarios are obtained directly from historical changes in market prices
and rates.
Let's look at the steps:
1. Collect Data: we identify the assets (local stocks) of our portfolio and
we collect the historical data on their returns over a set observation
period (i.e. 501 days after excluding the Ex-dividends days).
We choose the following local stocks :
A. The Housing bank (THBK), 4 million.
B. Jordan telecom (JTEL), 3 million.
C. Arab electronic (AEIN), 2 million.
D. ZARA Investment (ZARA), 1 million.
2. Generate Scenarios: for each asset and each t in the observation
period, we generate scenarios by calculating the return (% change) on
each of the assets. The formula used to calculate the percentage price
changes is: (price t - price t-1) / price t-1
3. Calculate Portfolio Return: by multiply the return for each asset by its
weight (notional investment).
4. Reorder Results: the portfolio returns have been sorted from largest
losses to the lowest one. We have 500 scenarios and the VaR @ 99%
confidence level is the 5th worst value (500 observations * 1%).

VaR VALUE @ 99% CONFIDENCE LEVEL

The 5th worst value: (141,017) JD.
Expected shortfall: (172,094) JD.
VaR is calculated using the assumption that the returns are normally
distributed and hence we used the formula
VaR= Mean-SD*NORMSINV (0.99)
Mean
Standard Deviation
Z-Value @ 99%

4,147
63,920
2.3263
2

VaR @ 99%

(144,554)

VaR under normal distribution assumption is greater than the VaR value
found under basic historical simulation approach , which means the returns
are not perfectly normally distributed ( data are skewed to the left, Skewness
= (0.094698) ).

Histogram

Frequency

80
70
60
50
40
30
20
10
0

Frequency

Bin

Cornish Fisher Expansion:

We need to adjust the distribution for the skewness by estimating adjusted
value of Z that accounts for the skwenesss and hence we use the adjusted Z
to calculate VaR.
After calculating the adjusted Z-value, we got VaR = (157,298), this compare
to the above VaR which is equal to (144,554).
That means the VaR under normal distribution assumption is undervalued and
the Z-value made up this difference.
Calculating VaR Using weighted Historical Simulation Approach
We suggest that more recent observations should be given more
weights because they are more reflective of current volatilities and
current macroeconomic conditions.
We calculate the weights by choosing lambda = 0.94
The ith weight = [^ (n - i) * (1 - )] / 1 - ^ (n)
We ranked the weights (based on the above equation) depending on
the losses from the largest loss to the smallest.

 Then, we calculate the cumulative weights for each day, after that we
applied the interpolation method to arrive at the 99% VaR.
We got the VaR value as 114,637 after interpolating between the
eighteenth and the nineteenth largest losses, The reason for getting a
lower VaR value than the basic approach (which is 141,017) is that the
recent observations are given more weights whereas the largest losses
occurred in the far past (some of them occurred more than a year ago
and others occurred at the beginning of the first year) (the old
observations were given low weights).
When we followed the same approach with lambda=0.5, the VaR value
we got after interpolating is 114,682 JD. The reason behind this result
is scenario number 498 which got a very big weight compared to upper
scenario (301 scenario ) after ranking; this causes a sudden increase in
the value of the cumulative weight from almost zero to 0.125, and the
1% is closer to the scenario 301 ( which has a higher loss ) than
scenario 498.

Scenario Number

Losses

Weight

301
498

(114,715)
(114,301)

0.000
0.125

Cumulative
Weight
0.000
0.125

The expected shortfall = 135,967

Calculating VaR Using Volatility-adjusted approach (EWMA)

When the exponentially weighted moving average(EWMA) method is

used , we got the VaR=157,083 JD, this is because the effect of the
multiplier value which has an amount of more than 1 most of the time (
magnifying the losses upward ) so more variability in the losses has
been created.
Expected shortfall = 176,436 JD.
Calculating VaR Using GARCH model approach

By using GARCH model, we got the VaR value as 154,398 JD.

Since GARCH makes adjustment to up normal losses under the
assumption that the market conditions are normal, the losses we got
4

are less than the losses we got under EWMA approach, and hence we
got a lower VaR under GARCH model.
Expected shortfall = 169,082 JD.
Variance - Covariance Approach for calculating Value at Risk
This method assumes that the daily returns follow a normal
distribution. From the distribution of daily returns we estimate the
standard deviation. The daily Value at Risk VaR is simply a function of
the standard deviation and the desired confidence level. In the
Variance Covariance VaR method the underlying volatility may be
calculated either using a simple moving average (SMA) or an
exponentially weighted moving average (EWMA).
The Variance Covariance VaR method makes a number of assumptions.
The accuracy of the results depends on how valid these assumptions
are. The method gets its name from the Variance covariance matrix of
securities that is used to calculate Value at Risk (VaR).
The method starts by calculating the standard deviation and
correlation for the risk factor and then uses these values to calculate
the standard deviations and correlation for the changes in the value of
the individual securities that form the position. If price, Variance and
correlation data is available for individual securities then this
information is used directly. The values are then used to calculate the
standard deviation of the portfolio.
This method does not generate the Variance covariance matrix and
uses the following approach:
Separate the portfolio in a long side and a short side.
Calculate the return series for the long side and the short side.
Use the return series to calculate the correlation and Variances for the
long and short sides
Use the results in (3) to calculate the VaR.
By applying the model building approach which assumes that the
portfolios returns are normally distributed, we constructed the
variance covariance matrix of the data to find the SD of the portfolio.
The one day VaR=148,552 compared to 141,017 when the basic
historical approach has been used.
When we used the EWMA to calculate variance covariance matrix , the
one day VaR =182,612 JD, this refers to the increase in the SD of the
portfolio caused by the increase in the SD of the returns due to having
5

multipliers more than one most of the time for three securities out of
four.
Monte Carlo Simulation for calculating Value at Risk (VaR)

We use this method when we dont have sufficient historical data.

This method is used to generate values to expect future returns, we
except long term return plus some random factor.

A Monte Carlo simulator uses random numbers to simulate the real

world. A Monte Carlo VaR model using the following sequence of steps :
1. The portfolio mean and the standard deviation of the real existing
sample will be used.
2. We use the function (RAND) to create as much random numbers as
much we need.
3. We find the Z-value for these numbers.
4. We use the following formula to expect the daily returns: Return=
+Z*
5. We find the SD for the numbers we got in step 4.
6. VaR= mean( for the expected future returns ) SD( we got in step 5 ) *
NORMSINV(0.99)
By changing the random numbers we got a new value of VaR.
Method
Basic Normal Distribution

VaR
(144,554)

Cornish Fisher Expansion

(157,298)

Historical Simulation Approach

Weighted historical Simulation Approach
(= 0.94)
Weighted historical Simulation Approach
(= 0.50)
EWMA
GARCH
Variance-Covariance Approach

(141,017)
(114,637)

Expected Shortfall
The Average Loss Value >
(144,554)
The Average Loss Value
>(157,298)
(172,094)
(135,965)

(114,682)

(135,967)

(157,083)
(154,398)
(148,552)

Variance-Covariance Approach (EWMA)

(182,612)

Monte-Carlo Simulation

Depends on
the random
Numbers

(176,436)
(169,082)
The Average Loss Value >
(148,552)
The Average Loss Value >
(182,612)
The Average Loss Value> VaR

Advantages and Disadvantages of the Historical Simulation Approach

There are a number of benefits to using the historical simulation
approach when calculating value at risk:
1. Simple (historical data publicly available or already collected in-house,
only a few simple steps: collecting, simulating, calculating, ordering)
2. No Normality Assumption (not dependent on assumptions regarding
the shape of the distribution of asset returns, may reflect any kurtosis
in the markets caused by chaotic events)
3. Non-parametric (eliminates the possibility of incorrectly estimating
certain parameters such as volatility and correlation, parameters
already reflected in the historical data, no pricing model critical
dependency)
4. Comprehensive (can be applied to any type of financial position
including non linear products)
Although there are advantages to using the historical simulation approach,
there are also drawbacks
1. Reliance on the past (assumes that a particular historical data set
provides a reliable estimate of future risks, can lead to bias in the VaR
estimate)
2. Length of estimation period (can critically influence the estimate of
VaR)
3. Weighting of data (same weight on all observations in the sample, one
observation may therefore significantly distort the VaR estimate when
it drops out of the sample range - solution: weighted historical
simulation)
4. Data issues (obtaining historical data may have a cost)
Quick Review of Value at Risk (VaR) Methods
Historical
Simulation VaR

Risks of
Yes,
portfolios that regardless of the
contain options option content

Variance / Covariance VaR

Monte Carlo
Simulation VaR

No,
except when computed using a
Yes,
short holding period with limited regardless of
or moderate
the option content
option content

VaR
Computation
performed
quickly

Yes

Yes

No,
except for relatively
small portfolios

VaR method
easy to explain
Yes
to senior
management

No

No

Yes,
except that
alternative correlation may be
used

Yes,
except that
alternative correlation
may be used

Misleading VaR
estimates
Yes
when recent
past is not
representative