Robust risk management: Accounting for nonstationarity and heavy tails

Ying Chen and Vladimir Spokoiny

No 2007-002, SFB 649 Discussion Papers from Humboldt University Berlin, Collaborative Research Center 649: Economic Risk

Abstract: In the ideal Black-Scholes world, financial time series are assumed 1) stationary (time homogeneous) and 2) having conditionally normal distribution given the past. These two assumptions have been widely-used in many methods such as the RiskMetrics, one risk management method considered as industry standard. However these assumptions are unrealistic. The primary aim of the paper is to account for nonstationarity and heavy tails in time series by presenting a local exponential smoothing approach, by which the smoothing parameter is adaptively selected at every time point and the heavy-tailedness of the process is considered. A complete theory addresses both issues. In our study, we demonstrate the implementation of the proposed method in volatility estimation and risk management given simulated and real data. Numerical results show the proposed method delivers accurate and sensitive estimates.

Keywords: exponential smoothing; spatial aggregation (search for similar items in EconPapers)
JEL-codes: C14 C53 (search for similar items in EconPapers)
Date: 2007
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:sfb649:sfb649dp2007-002

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