Question

compare with variance-covariance method and historical method，and advantages and disadvantages，please use your own words to explain，thanks.

Answer 1

Solution:

The main point of comparison between the variance-covariance method and historical method lies in the fact that the former simplifies the computation of VAR by assuming that the risk factors are normally distributed while the assumption of normality does not hold true in the historical method.

	Variance-Covariance Method	Historical Method
Advantages	1) As the normal distribution is assumed to be true the probability of extreme events is minimal. 2) More easier to implement. 3) This method have a high level of precision.	1) Non Linear instruments such as options can be accounted for. 2) Generally methods such as Monte Carlo need large number of iterations. 3) Not very accurate for a short period of time.
Disadvantages	1) Being normally distributed the effect of non linear instruments is not accounted for. 2) Also normal distribution does not hold true rather kurtosis and skewness always holds true (Fat tails)	1) This method replicates the actual distribution of risk and hence is more general in nature and there are high chances of outliers being in there. 2)Cannot account for events such as spikes in risk factors or unusual events and variation in risk over time.