Explanation:
Basic historically simulated VaR weighs all past observations equally and implicitly assumes that volatility remains constant over the historical window. In reality, financial risk factors often demonstrate "volatility clustering," meaning that periods of high volatility are followed by high volatility. If a model fails to incorporate time-varying volatility, it will be too slow to react when the market suddenly enters a volatile state, continuing to give too much weight to older, calmer days. As a result, it will significantly under-estimate risk during those periods of heightened volatility.
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Q.55 According to academic literature, “time-varying volatility in financial risk factors is important to the VaR.” When the true underlying risk factors exhibit time-varying volatility, the use of historically simulated VaR without incorporating time-varying volatility can:
A
Reduce pro-cyclicality
B
Under-estimate risk
C
Increase instability
D
Over-estimate risk
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