A Probabilistic Approach to Worst Case Scenarios

Barone-Adesi, Giovanni ; Bourgoin, Frederick ; Giannopoulos, Kostas (1997)


Value at Risk (VaR) is increasingly popular as a management and regulatory tool. To further its acceptance it is necessary to assess its reliability under conditions likely to be encountered in financial markets. A logical venue to investigate this issue is through the use of historical simulation.Historical simulation relies on a uniform distribution to select innovations from the past. These innovations are applied to current asset prices to simulate their future evolution. Once a sufficient number of different paths has been explored it is possible to determine a portfolio VaR without making arbitrary assumptions on the distribution of portfolio returns. This is especially useful in the presence of abnormally large portfolio returns.

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