LO 45.1: Explain the importance and challenges of extreme values in risk

LO 45.1: Explain the importance and challenges of extreme values in risk management.
The occurrence of extreme events is rare; however, it is crucial to identify these extreme events for risk management since they can prove to be very costly. Extreme values are the result of large market declines or crashes, the failure of major institutions, the outbreak of financial or political crises, or natural catastrophes. The challenge of analyzing and modeling extreme values is that there are only a few observations for which to build a model, and there are ranges of extreme values that have yet to occur.
To meet the challenge, researchers must assume a certain distribution. The assumed distribution will probably not be identical to the true distribution; therefore, some degree of error will be present. Researchers usually choose distributions based on measures of central tendency, which misses the issue of trying to incorporate extreme values. Researchers need approaches that specifically deal with extreme value estimation. Incidentally, researchers in many fields other than finance face similar problems. In flood control, for example, analysts have to model the highest possible flood line when building a dam, and this estimation would most likely require a height above observed levels of flooding to date.
E x t r e m e V a l u e T h e o r y

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