Delta Normal VaR
One of the simplest ways to calculate value at risk (VaR) is to make what are known as delta-normal assumptions. For any underlying asset, we assume that the log returns are normally distributed, and we approximate the returns of any option based on its delta-adjusted exposure. For portfolios, the delta-normal model assumes that the relationships between securities can be fully described by their correlation.
The delta-normal assumptions make it very easy to calculate VaR statistics even with limited computing power. This made delta-normal models a popular choice when VaR models were first introduced. Predictably, the results of such a simple model were often disappointing. Delta-normal models are rarely used in practice today, but are still an excellent starting point when learning about VaR models. By understanding the pros and cons of the delta-normal model we will be better able to understand the pros and cons of more complex models. Unfortunately many people outside of risk management believe that delta-normal models are still widely used in practice, or believe that the shortcomings of these simple models are somehow inherent to all risk models.