What is historical simulation?
In finance, historical simulation refers to a procedure predicting the value at risk (VaR) by 'simulating' or constructing the cumulative distribution function (CDF) of assets returns over time. Historical simulation is used in value at risk (VaR) analysis.
Where have you heard about historical simulation?
Historical simulation is a popular method, particularly among banks. In 2010, Christophe Pérignon and Daniel Smith reported that out of the banks that disclosed their methodology for calculating value-at-risk, 73% of them used historical simulation.
What you need to know about historical simulation.
Historical simulation uses real data, therefore it is able to capture unexpected events and correlations that wouldn't normally be predicted or considered by a theoretical model. Other benefits of using historical simulation is that it's free of assumptions and also fairly easy to explain. A potential flaw of historical simulation is that it relies on historical data, so if the market changes at all (as a result of new technology or economic expansion or decline, for example), the data may not be accurately reflective.