Extreme value theory performance in the event of major financial crises

Adrian F. Rossignolo, Meryem Duygun Fethi and Mohamed Shaban

International Journal of Banking, Accounting and Finance, 2012, vol. 4, issue 2, 94-134

Abstract: Current directives issued by the Basel Committee have established value-at-risk (VaR) as the standard measure to quantify market risk. In view of the wide range of applications and regulatory requirements, the development of accurate techniques becomes a topic of prime importance. VaR should protect market participants against sudden jerks in financial markets. While most models achieve that purpose for common everyday movements, they fail to account for unexpected crises. Extreme value theory (EVT) provides a method to estimate VaR at high quantiles of the distribution focusing on unusual circumstances. This paper employs EVT to calculate VaR for ten stock market indices belonging to developed and emerging markets in two different ways: unconditional EVT on raw returns and conditional EVT through quasi-maximum likelihood. The performance of EVT representations during the 2008 turmoil reveals that this methodology could have helped institutions to avoid huge losses arising from market disasters. A simple exercise on the constitution of Regulatory Capital illustrates the advantages of EVT.

Keywords: value-at-risk; VaR; historical simulation; financial crisis; extreme value theory; EVT; general autoregressive conditional heteroskedastic; GARCH; market risks; stock markets; financial markets. (search for similar items in EconPapers)
Date: 2012
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