Assessing Value at Risk in the Presence of Non-Normal Distribution

Hard Risk Management Applications Value At Risk

The portfolio manager of Alpha Investments is evaluating the risk exposure of a diversified equity portfolio worth $10 million. To assess potential losses, they decide to calculate the Value at Risk (VaR) at a 95% confidence level over a one-month horizon. The manager uses historical simulation with a look-back period of two years and finds that the worst daily loss has been $50,000. The annualized volatility of the portfolio returns is estimated at 20%.

The manager wants to ensure that the VaR estimation reflects potential extreme losses accurately. Considering the distribution of returns is not normal and shows considerable skewness and kurtosis, the portfolio manager is concerned that traditional VaR techniques may underestimate the risk.

Which of the following statements accurately reflects the situation regarding the Value at Risk calculation for Alpha Investments?

The historical simulation VaR method is appropriate because it captures extreme values from past returns.

The calculated VaR is likely to underestimate the risk due to the non-normal distribution of returns.

The 95% confidence level implies that the portfolio will not incur losses exceeding VaR within the specified timeframe.

Hint

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