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FRM Part II · FRM Exam Part II · Estimating Market Risk Measures: An Introduction and Overview

A bank uses basic historical simulation with an equally weighted window of 250 days. After a calm year, a sudden volatility spike occurs, yet the reported VaR rises only slightly over the following days. What is the best explanation?

Basic historical simulation weights all observations equally, so a few new volatile days are diluted by many calm ones in the window. The VaR quantile therefore adjusts slowly to a volatility spike, making the measure slow to react to changing conditions.

  1. AHistorical simulation assumes normally distributed returns, which understates tails
  2. BEach observation has equal weight and the window contains mostly calm data, so VaR responds slowly to new volatilityCorrect
  3. CHistorical simulation uses Monte Carlo draws that smooth out recent shocks
  4. DThe window length of 250 days is too short to contain any extreme observations

Explanation

Equal weighting means a few new large losses are diluted among many calm observations, and the VaR quantile moves only when enough tail observations accumulate. The method is non-parametric, so it makes no normality assumption. It does not use Monte Carlo draws. Window shortness is not the cause of the slow response.

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