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Evaluating the RiskMetrics methodology in measuring volatility and Value-at-Risk in financial markets

  • Pafka, Szilárd
  • Kondor, Imre

We analyze the performance of RiskMetrics, a widely used methodology for measuring market risk. Based on the assumption of normally distributed returns, the RiskMetrics model completely ignores the presence of fat tails in the distribution function, which is an important feature of financial data. Nevertheless, it was commonly found that RiskMetrics performs satisfactorily well, and therefore the technique has become widely used in the financial industry. We find, however, that the success of RiskMetrics is the artifact of the choice of the risk measure. First, the outstanding performance of volatility estimates is basically due to the choice of a very short (one-period ahead) forecasting horizon. Second, the satisfactory performance in obtaining Value-at-Risk by simply multiplying volatility with a constant factor is mainly due to the choice of the particular significance level.

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File URL: http://www.sciencedirect.com/science/article/pii/S0378437101003107
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Article provided by Elsevier in its journal Physica A: Statistical Mechanics and its Applications.

Volume (Year): 299 (2001)
Issue (Month): 1 ()
Pages: 305-310

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Handle: RePEc:eee:phsmap:v:299:y:2001:i:1:p:305-310
Contact details of provider: Web page: http://www.journals.elsevier.com/physica-a-statistical-mechpplications/

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  1. Galluccio, Stefano & Bouchaud, Jean-Philippe & Potters, Marc, 1998. "Rational decisions, random matrices and spin glasses," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 259(3), pages 449-456.
  2. Laurent Laloux & Pierre Cizeau & Jean-Philippe Bouchaud & Marc Potters, 1998. "Noise dressing of financial correlation matrices," Science & Finance (CFM) working paper archive 500051, Science & Finance, Capital Fund Management.
  3. Stefano Galluccio & Jean-Philippe Bouchaud & Marc Potters, 1998. "Rational decisions, random matrices and spin glasses," Science & Finance (CFM) working paper archive 500054, Science & Finance, Capital Fund Management.
  4. Nelson, Daniel B., 1992. "Filtering and forecasting with misspecified ARCH models I : Getting the right variance with the wrong model," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 61-90.
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