I am a newbie and was after a simple explanation on how VaR is calculated for a portfolio of IRS's.
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5$\begingroup$ Hi and welcome. What have you tried so far? Do you know how to calculate VaR for a simpler instrument, say a stock? Do you know how to compute VaR for a portfolio? Do you know how to bootstrap interest rate curves? $\endgroup$– KermittfrogJan 13 at 14:25
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Here is one very simple approach. However the devil is in the details.
Choose some benchmark tenors (market factors), e.g. 1Y, 2Y... 30Y swap rates.
For each tenor, calculate the P&L if the interest rate at this tenor moves 1 basis point, ceteris paribus. This gives you the vector of sensitivities to market factors.
Calculate the covariance matrix for your market factors, based on a few years of their historical changes.
Perform a matrix muliplication. Multiply the result of the matrix multiplication by the Z value for the desired probability.
(This is very similar to what you would do for a VaR of a portfolio consisting of spot positions in several foreign currencies. I wrote in detail about that here recalculate VaR from one currency to another )
This would be "good enough" for a simple portfolio. However most firms large enough to trade interest rate swaps usually do something more complicated for their VaR.
answered Jan 13 at 14:32