Answer-first summary for fast verification
Answer: Underestimate the true VaR.
## Explanation **Fat tails** (leptokurtosis) in return distributions mean: - More extreme observations than predicted by a normal distribution - Higher probability of large losses than the normal distribution suggests **Delta-Normal Method Assumptions:** - Assumes **normal distribution** of returns - Uses mean and variance to estimate risk **Impact of Fat Tails:** - The delta-normal method **underestimates** the probability of extreme losses - Since VaR measures potential extreme losses, the delta-normal VaR will be **too low** - The true VaR (considering fat tails) would be **higher** **Key Points:** - Fat tails = more extreme events than normal distribution predicts - Delta-normal method doesn't capture these extreme events properly - Therefore, it **underestimates** the true risk - More sophisticated methods (historical simulation, Monte Carlo) are needed for fat-tailed distributions **Correct Answer: A** - The delta-normal VaR underestimates the true VaR in the presence of fat tails.
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In the presence of fat tails in the distribution of returns, VaR based on the delta-normal method would (for a linear portfolio):
A
Underestimate the true VaR.
B
Be the same as the true VaR.
C
Overestimate the true VaR.
D
Cannot be determined from the information provided.
