Estimation Risk in Financial Risk Management

Value-at-Risk (VaR) and Expected Shortfall (ES) are increasingly used in portfolio risk measurement, risk capital allocation and performance attribution. Financial risk managers are therefore rightfully concerned with the precision of typical VaR and ES techniques. The purpose of this paper is exactly to assess the precision of common models and to quantify the magnitude of the estimation error by constructing confidence bands around the point VaR and ES forecasts. A key challenge in constructing proper confidence bands arises from the conditional variance dynamics typically found in speculative returns. Our paper suggests a resampling technique which accounts for parameter estimation error in dynamic models of portfolio variance. In a Monte Carlo study we find that commonly used practitioner methods such as Historical Simulation, which calculates the empirical quantile on a moving window of returns, implies 90% VaR confidence intervals that are too narrow and that contain as few as 20% of the true VaRs. Other methods which properly account for conditional variance dynamics, such as Filtered Historical Simulation instead imply 90% VaR confidence intervals that contain close to 90% of the true VaRs. ES measures are generally less accurate than VaR measures and the confidence bands around ES are also less reliable.
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