Challenges in the Application of Extreme Value Theory in Emerging Markets: A Case Study of Pakistan

Jamshed Uppal and Syeda Rabab Mudakkar

A chapter in Risk Management Post Financial Crisis: A Period of Monetary Easing, 2014, vol. 96, pp 417-437 from Emerald Group Publishing Limited

Abstract: Application of financial risk models in the emerging markets poses special challenges. A fundamental challenge is to accurately model the return distributions which are particularly fat tailed and skewed. Value-at-Risk (VaR) measures based on the Extreme Value Theory (EVT) have been suggested, but typically data histories are limited, making it hard to test and apply EVT. The chapter addresses issues in (i) modeling the VaR measure in the presence of structural breaks in an economy, (ii) the choice of stable innovation distribution with volatility clustering effects, (iii) modeling the tails of the empirical distribution, and (iv) fixing the cut-off point for isolating extreme observations. Pakistan offers an instructive case since its equity market exhibits high volatility and incidence of extreme returns. The recent Global Financial Crisis has been another source of extreme returns. The confluence of the two sources of volatility provides us with a rich data set to test the VaR/EVT model rigorously and examine practical challenges in its application in an emerging market.

Keywords: Value-at-risk; GARCH models; extreme value theory; back-testing; global financial crisis (search for similar items in EconPapers)
Date: 2014
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Persistent link: https://EconPapers.repec.org/RePEc:eme:csefzz:s1569-375920140000096018

DOI: 10.1108/S1569-375920140000096018

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