Monte Carlo simulation is subject to model risk.

The historical method uses actual returns for the position in question. An advantage of the historical method is not having to assume any particular distribution. A disadvantage is that it assumes past performance is representative of what can occur in the future, which may not be the case. The Monte Carlo simulation method for calculating VAR usually involves generating random numbers with a computer. The generated numbers represent possible returns of the asset or portfolio. An advantage is that Monte Carlo simulation does not require the normality assumption and can accommodate the required assumptions for complex relationships. A disadvantage is the requirement for many managerial assumptions and a great deal of computer time and calculations. The historical method and Monte Carlo Simulation both suffer from modeling risk.

The historical method uses actual returns for the position in question. An advantage of the historical method is not having to assume any particular distribution. A disadvantage is that it assumes past performance is representative of what can occur in the future, which may not be the case. The Monte Carlo simulation method for calculating VAR usually involves generating random numbers with a computer. The generated numbers represent possible returns of the asset or portfolio. An advantage is that Monte Carlo simulation does not require the normality assumption and can accommodate the required assumptions for complex relationships. A disadvantage is the requirement for many managerial assumptions and a great deal of computer time and calculations. The historical method and Monte Carlo Simulation both suffer from modeling risk.

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The delta-normal method uses means and variances and makes calculations under the assumption that the distribution of returns is normal.

The historical method uses past values and makes no explicit assumptions about inputs. It assumes that past patterns are indicative of future patterns.

For the Monte Carlo method, the advantages are that it does not require the normality assumption, and it is flexible insofar as it can accommodate a variety of assumptions regarding complex relationships. The main disadvantage is that it is often computationally intensive.

VAR is relatively incomparable across managers due to its inherent model risk. For example, two people can be given an assignment to compute the VAR for the same underlying asset and the results will likely be different due to the use of different methodologies and model assumptions. Neither answer is necessarily wrong. The bottom line here is that peer group evaluation using VAR is not very useful unless one can be sure that the same VAR techniques and assumptions are used to evaluate all portfolios.

Burns is incorrect and Smith is incorrect. A particular VAR estimate is based on a given model and its parameters. In stress testing (or scenario analysis), the analyst varies the inputs to the VAR estimation process sometimes to the extreme and analyzes the impact of this movement on the computed VAR. Stress testing is "what if" analysis, and its main contribution is that it shows how reliable a particular VAR estimate is.

The fundamental problem with VAR analysis is that the analyst must estimate the "true" probability distribution for the asset or portfolio under evaluation. This means that in order to give the analyst reliable results, the quantitative model must accurately describe the price process of the asset.

Banks is correct but Myers conclusion is incorrect. Since credit risk increases when the value of the position held increases, we should focus on the upper not lower tail of the distributions of gains on positions held.

A key advantage of Monte Carlo simulation is the ability to deal with the assumptions required to handle complex relationships. McAdams statement is correct. The key advantage of the historical method is that you do not have to assume a particular distribution. Therefore, Blatt is incorrect. A major disadvantage of the historical method is that we have to assume that past performance is representative of future performance; it is not a disadvantage of the variance-covariance method. Therefore, Berry is also incorrect.