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FRM Part II · FRM Exam Part II · Parametric Approaches (II): Extreme Value

A risk analyst notes that daily losses exhibit volatility clustering and wants to apply EVT to a VaR estimate. Which approach best addresses the violation of the iid assumption?

Fit a GARCH-type volatility model, apply EVT to the standardized residuals, which are roughly iid, and rescale by the current volatility forecast. This conditional EVT approach handles volatility clustering, while ignoring it or using a normal tail would misstate extreme losses.

  1. AFit a GARCH-type model first and apply EVT to the standardized residuals, then rescale using the current volatility forecastCorrect
  2. BApply EVT directly to raw losses and ignore clustering
  3. CIncrease the threshold until all clustering disappears
  4. DReplace the GPD with a normal distribution for the tail

Explanation

Conditional EVT filters out time-varying volatility with a GARCH-type model, applies EVT to approximately iid standardized residuals, and rescales by the current volatility forecast. Ignoring clustering violates the iid assumption, and a normal tail would understate extreme risk.

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