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FRM Part II · FRM Exam Part II · Non-parametric Approaches

A portfolio manager uses historical simulation with a 250-day window. A major market shock occurred 251 days ago and has just dropped out of the window, while recent market conditions are calm. Which outcome is most likely, and which limitation of historical simulation does it illustrate?

VaR will likely drop abruptly because basic historical simulation gives equal weight to every observation in the window, so an extreme loss influences VaR fully until it exits. This is the ghost effect, which age-weighting schemes are designed to soften.

  1. AReported VaR falls abruptly, illustrating the 'ghost effect' of equal-weighted observations dropping out of the windowCorrect
  2. BReported VaR rises sharply because calm data increases estimation error
  3. CReported VaR is unchanged because historical simulation ignores window length
  4. DReported VaR falls gradually over many days because older observations are weighted less

Explanation

Basic historical simulation weights all observations in the window equally, so an extreme observation affects VaR fully until it leaves the window, then disappears abruptly. This is the ghost or drop-out effect. Gradual decline would occur under age-weighted schemes, not equal weighting.

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