What is the primary disadvantage of historical VAR?

The primary disadvantage of historical Value at Risk (VaR) lies in its reliance on historical data. Historical VaR calculates potential losses based purely on past market data, assuming that future market conditions will resemble those of the past. This reliance means that the model may fail to account for changes in market dynamics, asset volatility, or other economic factors that differ from historical trends.

For instance, if a financial crisis or unprecedented market event occurs, historical data might not reflect the extent of potential losses because such events could be significantly different from historical patterns. Consequently, while historical VaR can be a useful tool for estimating risk, its dependence on history limits its effectiveness in adapting to new market realities or extreme events that have not occurred previously.

This highlights the importance of using historical VaR in conjunction with other risk assessment methodologies to ensure a comprehensive understanding of potential risks.