Explanation:
Standard historical simulation assumes that all returns within the historical window are independent and identically distributed (i.i.d.), ignoring conditional (time-varying) volatility. When volatility spikes in current market conditions, unadjusted historical simulation reacts very slowly and mostly reflects past calm periods, leading to an under-estimation of risk. Conversely, during low-volatility periods following a crisis, it tends to over-estimate conditional risk. Underestimating risk during periods of market stress is considered its most crucial flaw.
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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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