Question #8
Reading: Reading 37 Measuring and Managing Market Risk
PDF File: Reading 37 Measuring and Managing Market Risk.pdf
Page: 4
Status: Incorrect
Correct Answer: A
Your Answer: B
Part of Context Group: Q7-8
Shared Context
Question
How many of Manning's limitations of VaR are incorrect?
Answer Choices:
A. 1 limitation
B. 2 limitations
C. 3 limitations
Explanation
Limitation 1 is incorrect. Platykurtic distributions have fewer extreme outliers than a
normal distribution (thinner tails). A normal distribution would therefore overestimate the
potential losses. A leptokurtic distribution would have fatter tails and therefore the normal
distribution would underestimate potential losses.
Limitation 2 is correct. If the look back period is a period of relative normality, then the
calculated correlations will often overestimate the benefits of diversification. Correlations
will tend to spike during periods of financial distress resulting in larger losses than VaR
based on look back period would estimate.
Limitation 3 is correct. During periods of financial distress, liquidity tends to drop in the
market. VaR does not account for changes in liquidity and will therefore tend to
underestimate the actual losses.