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FRM Part I · FRM Exam Part I · Measuring and Monitoring Volatility

In the EWMA model, which statement about the decay factor lambda is correct?

A lower lambda puts more weight on the most recent squared return, because that weight is one minus lambda. The estimate therefore reacts faster to new shocks and has shorter memory. A higher lambda gives smoother, slower-moving estimates.

  1. AA lower lambda gives more weight to recent squared returns, so the estimate reacts faster to new shocks.Correct
  2. BA lower lambda gives more weight to older observations, making the estimate smoother.
  3. CLambda must be below 0.5 so that weights sum to one.
  4. DLambda determines the long-run variance to which the estimate reverts.

Explanation

The weight on the latest squared return is (1 - lambda), so a lower lambda raises that weight and shortens memory, making the estimate more responsive. Higher lambda gives smoother estimates. The weights sum to one for any lambda between 0 and 1, and EWMA has no mean reversion.

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