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Answer: The filtered HS approach accommodates volatility clustering and allows positive and negative returns to impact volatility differently.
**Correct Answer: B** **Explanation:** B is correct. Filtered historical simulation accommodates conditionally changing volatility, volatility clustering, and allows for the "leverage effect", a phenomenon where positive and negative returns have differing impacts on volatility. **Why other options are incorrect:** - **A is incorrect:** The correlation-weighted historical simulation approach uses a variance-covariance matrix to adjust the returns in the data set. This is more complex than the volatility-weighted approach, which simply multiplies each return by the current volatility estimate divided by the historical volatility estimate. - **C is incorrect:** Volatility-weighted HS increases (decreases) a historical return observation if the current forecast of volatility is greater (less) than the historical forecast of volatility corresponding with the historical return observation. - **D is incorrect:** Age-weighted HS allows the risk management practitioner to choose a value of lambda that represents the exponential rate of decay in the weight given to an observation as it ages. This approach does not assume that the decay is linear. **Key Learning Points:** - Filtered HS captures volatility clustering and asymmetric volatility effects - Correlation-weighted HS uses variance-covariance matrix adjustments - Volatility-weighted HS scales returns based on current vs. historical volatility ratios - Age-weighted HS uses exponential decay rather than linear decay
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A junior risk analyst is asked to prepare a report comparing the various weighted historical simulation (HS) approaches. The analyst focuses on the ways the different HS approaches adjust the returns observed in the data set. Which of the following statements is correct for the analyst to make?
A
The correlation-weighted HS approach adjusts the return observations by multiplying each return by the current correlation divided by the historical correlation.
B
The filtered HS approach accommodates volatility clustering and allows positive and negative returns to impact volatility differently.
C
The volatility-weighted HS approach adjusts returns upward when the current volatility is below the long-term average volatility.
D
The age-weighted HS approach assumes that the value of the information contained in a return observation declines in a linear manner starting from the date it is first observed.
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