Question

You are a Financial Manager CRC Company Ltd. in calculations of the risk values, your Company applies a VaR system at 99% (relative) VaR values on a daily basis. Over the last 500 trading days (two years) there have been five occasions when the VaR values have been breached. A subordinate comes to you with some serious concerns in relation to the current VaR calculations, arguing that they wrongly represent correlations in behavior occurring at times when the markets make large movements. He has carried out a set of alternative calculations of daily (relative) VaR values over the last two years, which also has five occasions when the VaR values have been breached.

Required:

Explain why the alternative daily VaR values may differ markedly from the values from the current system, but have the same number of VaR breaches.

Answer 1

The time period for the observations are 500 daily trading days over 2 years horizon.The VaR incorporated in the system presently uses a significance level of 99%. This percentage signifies the level of confidence of the managers in estimating VaR. Level of confidence means the manager expects the worst loss will nt exceed more than the significance level. Significance level is determined using level of confidence.In our case the level of significance is 1%.

The subordinate also carries out the calculation amd have different values but same number of breaches.

This could be of the methods used to calculate the VaR. The financial manager must have used hisorical simulation method while the subordinate must have used Monte Carlo Simulation. The results will be different but the number of breaches are same.

Monte Carlo Simulation

The method involves developing a model for future stock price returns and running multiple hypothetical trials through the model. A Monte Carlo simulation refers to any method that randomly generates trials.

Historical Method

The historical method simply re-organizes actual historical returns, putting them in order from worst to best. It then assumes that history will repeat itself, from a risk perspective.