Simulation methods

TL;DRAbstract

There are numerous situations, in finance and in econometrics, where the researcher has essentially no idea what is going to happen! To offer one illustration, in the context of complex financial risk measurement models for portfolios containing large numbers of assets whose movements are dependent on one another, it is not always clear what will be the effect of changing circumstances. For example, following full European monetary union (EMU) and the replacement of member currencies with the euro, it is widely believed that European financial markets have become more integrated, leading the correlation between movements in their equity markets to rise. What would be the effect on the properties of a portfolio containing equities of several European countries if correlations between the markets rose to 99%? Clearly, it is probably not possible to be able to answer such a question using actual historical data alone, since the event (a correlation of 99%) has not yet happened.

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