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

Which of the following is a recognized advantage of non-parametric approaches such as historical simulation over parametric approaches for a portfolio containing options?

Non-parametric methods need no distributional assumption and use actual observed returns, so they capture fat tails, skewness and non-linear payoffs such as options through full revaluation. Their weaknesses are sample dependence, slow adaptation to volatility, and inability to extrapolate beyond observed losses.

  1. AThey need no assumption about the return distribution and can capture fat tails and skewness present in the dataCorrect
  2. BThey produce stable estimates from small samples
  3. CThey automatically adjust for changing volatility without modification
  4. DThey provide VaR estimates beyond the worst observed historical loss

Explanation

Non-parametric methods draw directly on observed data, so they capture skewness, fat tails and non-linear payoffs through full revaluation without distributional assumptions. They are sensitive to sample size, do not adjust to volatility unless modified, and cannot extrapolate beyond observed losses.

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