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VaR has become significant because it represents the first collective effort by themarket participants and regulators to create a standardized approach to assess risks, whether itis for a particular security, an investment portfolio or the entire balance sheet of anorganization. However, it is very important to emphasize that VaR is only a statisticalestimate usually based on an assumed distribution of some historical time series data. It is aforecast number and can not by nature be accurately determined with 100% degree of confidence. The common types of methodologies used to calculate this estimate number are:
1. Historical Price Modeling
In historical price modeling, one tries to construct a distribution of portfolio returnsfrom a series of changes in portfolio values based on a given time series of historical marketprices of basic component instruments such as FX, interest rates, stocks and commodities atthe beginning and the end of a given time horizon. From the distribution of the portfolioreturns we can calculate the potential portfolio loss, at a certain confidence interval, for aparticular holding period.Having the time series of portfolio returns, many statistical techniques could be usedto construct the distributions to determine the probability of loss for the portfolio. Forexample, if we assume the portfolio returns follow a normal distribution through time, theVaR under any level of confidence can be easily calculated from the product of a confidencelevel factor and the standard deviation of the portfolio returns distribution.(See Figure 1)
2. Estimated Variance and Covariance Method
A more pragmatic and convenient approach is to create a series of historical varianceand covariance matrix data on simplified financial instruments and then apply them to thosecomponent securities in a portfolio. Most portfolio risk factors can be broken down intoequivalent simplified instruments such as FX spot rates, money market rates, governmentbond prices, swap rates, stock market indices and commodities prices.