Incorporating volatility updating into the historical simulation method for value-at-risk

Abstract

This paper proposes a procedure for using a GARCH or exponentially weighted moving average model in conjunction with historical simulation when computing value at risk. It involves adjusting historical data on each market variable to reflect the difference between the historical volatility of the market variable and its current volatility. We compare the approach using nine years of daily data on 12 exchange rates and 5 stock indices with the historical simulation approach and show that it is a substantial improvement. 2 INCORPORATING VOLATILITY UPDATING INTO THE HISTORICAL SIMULATION METHOD FOR VALUE AT RISK John Hull and Alan White 1 University of Toronto 1. Introduction In recent years value at risk (VaR) has become a very popular measure of market risk. It is widely used by financial institutions, fund managers, and nonfinancial corporations to control the market risk in a portfolio of financial instruments. As discussed by Jorion (1997), it has been adopted by central bank r...