Historical simulation is a non-parametric approach to risk measurement that uses past data to model future potential losses. This technique calculates Value at Risk (VaR) by directly observing the distribution of historical returns and identifying the worst-case scenarios from the dataset. It relies on the assumption that future market movements will resemble past events in terms of probability and magnitude.
Data
The input data for historical simulation consists of a time series of portfolio returns over a specific lookback period. Analysts use this historical data to construct a distribution of potential profits and losses. The choice of lookback period is critical; a longer history provides a broader range of events but may include irrelevant past market regimes, while a shorter history captures recent dynamics but might miss rare events.
Evaluation
Evaluating risk using historical simulation involves ordering historical returns from worst to best to calculate VaR at a specific confidence level. This method is straightforward and avoids strong distributional assumptions common in parametric methods. It also captures non-linear price movements and tail risk more effectively, making it a valuable tool in highly volatile crypto markets.
