Challenges in Implementing Worst-Case Analysis

8 Pages Posted: 15 Mar 2017  

Jon Danielsson

London School of Economics - Systemic Risk Centre

Lerby Murat Ergun

London School of Economics & Political Science (LSE)

Casper G. de Vries

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Tinbergen Institute; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: March 1, 2017

Abstract

Worst-case analysis has increased in popularity among financial regulators in the wake of the recent financial crisis. In this paper we provide insight into this measure and provide some guidance on how to estimate it. We derive the bias for the non-parametric heavy tailed order-statistics and contrast it with the semi-parametric EVT approach. We find that if the return distribution has a heavy tail, the non-parametric worst-case analysis, i.e the minimum of the sample, is always downwards biased. Relying on semi-parametric EVT reduces the bias considerably in the case of relatively heavy tails. But for the less heavy tails this relationship is reversed. Estimates for a large sample of US stock returns indicates that this pattern in the bias is also present in financial data. With respect to risk management, this induces an overly conservative capital allocation.

Keywords: Worst-case analysis, EVT, quantile estimator, risk management

JEL Classification: C01, C14, C58

Suggested Citation

Danielsson, Jon and Ergun, Lerby Murat and de Vries, Casper G., Challenges in Implementing Worst-Case Analysis (March 1, 2017). Available at SSRN: https://ssrn.com/abstract=2925773

Jon Danielsson

London School of Economics - Systemic Risk Centre ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44.207.955.6056 (Phone)

HOME PAGE: http://www.riskreasearch.org

Lerby Murat Ergun (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Casper De Vries

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands
+31 10 408 8956 (Phone)
+31 10 408 9147 (Fax)

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands
+31 10 408 8956 (Phone)
+31 10 408 9147 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

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