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FRM Part II · FRM Exam Part II · Non-parametric Approaches

A risk analyst at a bank is comparing historical simulation with a parametric normal VaR approach for a portfolio containing options and other nonlinear positions. Which of the following is the most important advantage of historical simulation in this setting?

The key advantage is that historical simulation makes no distributional assumption. It uses actual past returns, so fat tails, skewness and nonlinear payoffs are captured in the sample. It does not weight recent data by default, is not especially stable, and cannot produce losses beyond the worst observed.

  1. AIt requires no assumption about the shape of the return distribution and captures fat tails and skewness present in the sampleCorrect
  2. BIt gives more weight to recent observations than to older ones by default
  3. CIt guarantees that VaR estimates will be stable from one day to the next
  4. DIt can forecast losses larger than any loss in the historical sample

Explanation

Historical simulation draws on actual past returns, so features such as fat tails, skewness and nonlinear payoffs are embedded without distributional assumptions. Equal weighting is the default, not recency weighting, so option B is wrong. The estimate can be unstable and cannot exceed the worst observed loss.

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