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    Data To Estimate The Model Parameters.: Model Building Approach Assumes Two Things

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    Jessuel Larn-eps
    The model-building approach assumes a joint distribution model for changes in market variables based on historical data. It uses this model to estimate parameters and calculate Value at Risk (VaR) by assuming daily percentage changes in market variables are normally distributed and the dollar change in a portfolio's value is linearly dependent on these percentage changes. This approach makes VaR calculation easy but has drawbacks if returns are not actually normally distributed or a portfolio includes nonlinear products like options. It provides quicker results than some alternatives and can be used with volatility and correlation procedures.

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    Data To Estimate The Model Parameters.: Model Building Approach Assumes Two Things

    Uploaded by

    Jessuel Larn-eps
    36 views1 page
    The model-building approach assumes a joint distribution model for changes in market variables based on historical data. It uses this model to estimate parameters and calculate Value at Risk (VaR) by assuming daily percentage changes in market variables are normally distributed and the dollar change in a portfolio's value is linearly dependent on these percentage changes. This approach makes VaR calculation easy but has drawbacks if returns are not actually normally distributed or a portfolio includes nonlinear products like options. It provides quicker results than some alternatives and can be used with volatility and correlation procedures.

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    The model-building approach assumes a joint distribution model for changes in market variables based on historical data. It uses this model to estimate parameters and calculate Value at Risk (VaR) by assuming daily percentage changes in market variables are normally distributed and the dollar change in a portfolio's value is linearly dependent on these percentage changes. This approach makes VaR calculation easy but has drawbacks if returns are not actually normally distributed or a portfolio includes nonlinear products like options. It provides quicker results than some alternatives and can be used with volatility and correlation procedures.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    36 views1 page

    Data To Estimate The Model Parameters.: Model Building Approach Assumes Two Things

    Uploaded by

    Jessuel Larn-eps
    The model-building approach assumes a joint distribution model for changes in market variables based on historical data. It uses this model to estimate parameters and calculate Value at Risk (VaR) by assuming daily percentage changes in market variables are normally distributed and the dollar change in a portfolio's value is linearly dependent on these percentage changes. This approach makes VaR calculation easy but has drawbacks if returns are not actually normally distributed or a portfolio includes nonlinear products like options. It provides quicker results than some alternatives and can be used with volatility and correlation procedures.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 1

    MODEL-BUILDING APPROACH

    In this approach, we assume a model


    for the joint distribution of changes in market variables and use historical
    data to estimate the model parameters. This model is also known as variance-covariance
    approach.

    The model-building approach is based on ideas pioneered by Harry


    Markowitz. We used these ideas for assessing the risk-return trade-offs
    in portfolios of stocks

    They can also be used to calculate


    VaR. Estimates of the current levels of the variances and covariances of
    market variables are made using the approaches described in Chapters 5
    and 6. If the probability distributions of the daily percentage changes in
    market variables are assumed to be normal and the dollar change in the
    value of the portfolio is assumed to be linearly dependent on percentage
    changes in market variables, VaR can be obtained very quickly.

    Daily returns on the investments are normally assumed to be multivariate normal which
    can be the models biggest drawback. Hence, model-building approach makes it easy to
    calculate Var.

    Model Building approach assumes two things:


    • The daily change in the value of a portfolio is linearly related to the daily returns from
    market variables
    • The returns from the market variables are normally distributed

    Shortcomings of Model Building Approach


    Also this approach is much more complex to use when a portfolio comprises of nonlinear
    products such as options. It is also a grim task to relax the assumption that returns are normal
    without a significant increase in totaling time.

    Model building approach producer quicker results and can be used in conjunction with volatility
    and other correlation procedures.

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