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

A risk manager uses basic historical simulation with a 500-day window and equal weights to compute 99% VaR. Volatility in the market has risen sharply over the last 10 days, but the portfolio's VaR barely changed. Which weakness of the method best explains this?

Equal weighting makes the estimate slow to react. Ten volatile days are only 2% of a 500-day window, so they barely move the 99% quantile. Age-weighted or volatility-weighted historical simulation is designed to correct this weakness, whereas normality is not assumed in the basic method.

  1. ASlow response to changes in volatility because recent and old observations carry equal weightCorrect
  2. BExcessive reliance on a normality assumption that understates the tails
  3. CInability to handle portfolios with more than one risk factor
  4. DOverstatement of VaR because extreme observations are removed from the sample

Explanation

With equal weights over 500 days, 10 recent high-volatility days make up only 2% of the sample, so the 99% quantile reacts slowly. Historical simulation does not assume normality and handles multiple factors, so the other options describe things it does not do.

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