Why VAR Fails: Long Memory and Extreme Events in Financial Markets

Cornelis Los

Finance from University Library of Munich, Germany

Abstract: The Value-at-Risk (VAR) measure is based on only the second moment of a rates of return distribution. It is an insufficient risk performance measure, since it ignores both the higher moments of the pricing distributions, like skewness and kurtosis, and all the fractional moments resulting from the long - term dependencies (long memory) of dynamic market pricing. Not coincidentally, the VaR methodology also devotes insufficient attention to the truly extreme financial events, i.e., those events that are catastrophic and that are clustering because of this long memory. Since the usual stationarity and i.i.d. assumptions of classical asset returns theory are not satisfied in reality, more attention should be paid to the measurement of the degree of dependence to determine the true risks to which any investment portfolio is exposed: the return distributions are time-varying and skewness and kurtosis occur and change over time. Conventional mean-variance diversification does not apply when the tails of the return distributions ate too fat, i.e., when many more than normal extreme events occur. Regrettably, also, Extreme Value Theory is empirically not valid, because it is based on the uncorroborated i.i.d. assumption.

Keywords: Long memory; Value at Risk; Extreme Value Theory; Portfolio Management; Degrees of Persistence (search for similar items in EconPapers)
JEL-codes: C33 G13 G14 G18 G19 G24 (search for similar items in EconPapers)
Pages: 26 pages
Date: 2004-12-08
New Economics Papers: this item is included in nep-ets, nep-fin, nep-fmk and nep-rmg
Note: Type of Document - pdf; pages: 26
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Related works:
Journal Article: Why VaR FailsLong Memory and Extreme Events in Financial Markets (2005)
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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpfi:0412014

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