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

A risk analyst at a bank uses historical simulation with a 500-day window to estimate 99% VaR for an equity portfolio. Markets have been calm for the last 400 days, after a volatile period earlier in the window. Which statement best describes a key weakness of the method in this situation?

Basic historical simulation weights every observation in the window equally, so VaR responds slowly to changes in volatility regime and can be dominated by older volatile data. It does not assume normality or need a covariance matrix, which are features of parametric approaches.

  1. AThe method assumes returns are normally distributed, so it understates tail losses
  2. BThe method gives equal weight to all observations in the window, so VaR may be slow to reflect the recent calm and may be dominated by older volatile observationsCorrect
  3. CThe method requires estimating a full covariance matrix, which becomes unstable for large portfolios
  4. DThe method cannot capture fat tails because it relies on a parametric tail distribution

Explanation

Basic historical simulation weights all observations in the window equally, so old volatile days continue to influence VaR and the estimate adapts slowly to changed conditions. It makes no normality assumption and needs no covariance matrix, so the other options describe parametric methods.

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