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

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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Jessuel Larn-eps
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60 views1 page

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

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.

Uploaded by

Jessuel Larn-eps
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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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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