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FRM Part I · FRM Exam Part I · Calculating and Applying VaR

Which statement about basic (equal-weighted) historical simulation VaR is most accurate?

Basic historical simulation reacts slowly to sudden increases in volatility because every observation in the window has equal weight. It is non-parametric, needs no normality or covariance matrix, and can reflect fat tails that appear in the sample.

  1. AIt assumes returns are normally distributed and estimates volatility from the sample
  2. BIt is slow to respond to a sudden rise in market volatility because old and recent observations carry equal weightCorrect
  3. CIt requires a covariance matrix of risk factors to be estimated
  4. DIt cannot capture fat tails because it uses only recent data

Explanation

Historical simulation is non-parametric and uses actual past changes, so it needs no distribution or covariance assumption and captures fat tails present in the sample. Its weakness is equal weighting: after a volatility jump, VaR adjusts slowly and ghost effects occur when large observations drop out of the window.

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