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Extreme Returns, Tail Estimation, and Value-at-Risk

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  • Jon Danielsson

Abstract

Accurate prediction of extreme events are of primary importance in many financial applications. The properties of historical simulation and Risk Metrics techniques for computing Valu-at Risk (VaR) are compared with a method which involves modelling the tails of financial returns explicitly with a tail estimator. The methods are compared using a sample of U.S. stock returns. For predictions of low probability worst outcomes, RiskMetrics type analysis underpredicts while historical simulation overpredicts. However, the estimates obtained from applying the tail estimator are more accurate in the VaR prediction. This implies that capital requirements can be lower by doing VaR with the tail estimator.

Suggested Citation

  • Jon Danielsson, 1997. "Extreme Returns, Tail Estimation, and Value-at-Risk," FMG Discussion Papers dp273, Financial Markets Group.
    • Handle: RePEc:fmg:fmgdps:dp273
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    File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmg_pdfs/dp273.pdf
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    References listed on IDEAS

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    1. J. S. Butler & Barry Schachter, 1996. "Improving Value-At-Risk Estimates By Combining Kernel Estimation With Historical Simulation," Finance 9605001, University Library of Munich, Germany.
    2. J. S. Butler & Barry Schachter, 1996. "Improving value-at-risk estimates by combining kernel estimation," Proceedings 513, Federal Reserve Bank of Chicago.
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    Cited by:

    1. Straetmans, Stefan, 2000. "Extremal spillovers in financial markets," Serie Research Memoranda 0013, VU University Amsterdam, Faculty of Economics, Business Administration and Econometrics.
    2. Peter F. Christoffersen & Francis X. Diebold, 2000. "How Relevant is Volatility Forecasting for Financial Risk Management?," The Review of Economics and Statistics, MIT Press, vol. 82(1), pages 12-22, February.
    3. Agata Gemzik-Salwach, 2012. "The Use Of A Value At Risk Measure For The Analysis Of Bank Interest Margins," "e-Finanse", University of Information Technology and Management, Institute of Financial Research and Analysis, vol. 8(4), pages 15-29, February.
    4. Xiongwei Ju & Neil D. Pearson, 1998. "Using Value-at-Risk to Control Risk Taking: How Wrong Can you Be?," Finance 9810002, University Library of Munich, Germany.

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