FRM Part II · FRM Exam Part II · Parametric Approaches (II): Extreme Value
A risk manager fits a generalized Pareto distribution to losses above a threshold and is deciding how to set the threshold. Which statement best describes the trade-off involved?
A low threshold brings in non-tail observations and biases the tail estimates, while a high threshold leaves few exceedances and raises estimator variance. The threshold choice therefore balances bias against variance. Saying a higher threshold lowers variance reverses this relationship.
- AA higher threshold lowers the variance of the tail parameter estimates but increases bias because fewer observations are used
- BA lower threshold increases the bias of the tail estimates because it admits observations that are not in the tail, while a higher threshold increases estimator variance because fewer exceedances remainCorrect
- CA lower threshold reduces both bias and variance because more data are used
- DThe threshold has no effect on estimates once the GPD is fitted by maximum likelihood
Explanation
Choosing the threshold is a bias-variance trade-off. Too low a threshold includes central observations that the GPD does not describe, causing bias. Too high a threshold leaves few exceedances, causing noisy estimates. The first option reverses the roles of bias and variance.
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