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

A risk manager notes that a 1-year historical simulation window used for VaR contains only a calm market period, and the VaR estimate is very low just before a volatility spike. Which weakness of equal-weighted historical simulation does this best illustrate?

This illustrates that historical simulation depends entirely on the chosen sample window. Events absent from the data, such as a volatility spike, cannot appear in the estimate, so VaR is understated after a calm period. The method does not assume normality.

  1. AThe method requires a normality assumption that fails in calm markets
  2. BThe estimate depends entirely on the window and cannot reflect events not in the sampleCorrect
  3. CThe method double counts correlations between risk factors
  4. DThe method overstates VaR because old data receives excess weight

Explanation

Historical simulation assumes the past sample represents the future; if the window lacks stress events, VaR will be too low. It makes no normality assumption, and correlations are captured implicitly through actual joint moves. The problem is under-representation of extreme events, not overstatement.

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