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FRM Part I · FRM Exam Part I · Calculating and Applying VaR

Which of the following is a recognized weakness of the basic historical simulation approach to VaR?

A key weakness is that historical simulation assumes the past sample represents the future, so extreme losses not in the window are ignored. It does not need normality or a covariance matrix and can handle option portfolios through full revaluation of positions.

  1. AIt requires the assumption that portfolio returns are normally distributed
  2. BIt cannot be applied to portfolios containing options
  3. CIt assumes the past distribution of returns is representative of the future, and extreme losses outside the sample window are ignoredCorrect
  4. DIt requires estimation of a full covariance matrix for all risk factors

Explanation

Historical simulation relies on the sample being representative and ignores events outside the window. It requires no normality assumption and no covariance matrix, and it handles options through full revaluation.

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