The Advantages of Factor Model-Based Risk Management Compared To The Historical Simulation Approach

Investment firms currently face a choice of approaches for risk management. For many who try to model market risk, it comes down to evaluating a factor model-based solution versus a simulation approach. So what is best practice in risk management?

TWO APPROACHES TO MODELLING MARKET RISK
Modelling market risk is a complex problem. Historically two broad approaches have been taken by academics and industry professionals: factor-based and simulation-based methodologies.

Factor methods have been favoured on the buy-side since the 1970s, but the popularity of VaR within banking risk management has grown since the early 1990s and has led to the development of simulation-based systems. These are offered to investment managers and hedge funds as investment risk products. The trend towards ever-increasing use of derivatives, and the wider range of underlying asset classes available to investors, poses challenges for both factor models and simulation approaches.

This SunGard APT article compares the relative advantages of factor models over historical simulation.

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