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

A risk manager notes that during a prolonged calm period, basic historical simulation VaR based on a 500-day window stays low even as market volatility has started rising sharply. Which is the most appropriate enhancement to make VaR more responsive to current conditions?

Volatility-weighted historical simulation is the best fix. It rescales each past return by the ratio of current volatility to the volatility prevailing when the return occurred, so VaR responds to rising volatility. Longer or equally weighted windows adapt more slowly.

  1. ALengthen the window to 2,000 days to include more observations
  2. BApply volatility-weighted historical simulation, rescaling past returns by the ratio of current to historical volatilityCorrect
  3. CReplace the historical returns with normally distributed returns of equal mean
  4. DEqual-weight all observations so recent data has no extra influence

Explanation

Volatility weighting adjusts each historical return by current volatility divided by the volatility at that time, so VaR reflects the present regime. A longer window and equal weighting make the measure even slower to react, and assuming normality abandons the non-parametric approach.

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