Hi,
This is a question out of a old GARP paper. Can you please help me understand why the answer looks at the left tail when explaining the answer. Why would one in this question ignore the right tail. Does the right tail not reflect the ES? Therefore if one argue the implied distribution is thiner on the right tail, therefore the ES will be smaller under the new approach. Thus the correct answer should be b.
The Chief Risk Officer of Martingale Investments Group is planning a change in methodology for some of the risk management models used to estimate risk measures. His aim is to move from models that use the normal distribution of returns to models that use the distribution of returns implied by market prices. Martingale Group has a large long position in the German equity stock index DAX which has a volatility smile that slopes downward to the right. How will the change in methodology affect the estimate of expected shortfall (ES)?
Explanation: A volatility smile is a common graphical shape that results from plotting the strike price and implied volatility of a group of options with the same expiration date. Since the volatility smile is downward sloping to the right, the implied distribution has a fatter left tail compared to the lognormal distribution of returns. This means that an extreme decrease in the DAX has a higher probability of occurrence under the implied distribution than the lognormal. The ES will therefore be larger when the methodology is modified.
This is a question out of a old GARP paper. Can you please help me understand why the answer looks at the left tail when explaining the answer. Why would one in this question ignore the right tail. Does the right tail not reflect the ES? Therefore if one argue the implied distribution is thiner on the right tail, therefore the ES will be smaller under the new approach. Thus the correct answer should be b.
The Chief Risk Officer of Martingale Investments Group is planning a change in methodology for some of the risk management models used to estimate risk measures. His aim is to move from models that use the normal distribution of returns to models that use the distribution of returns implied by market prices. Martingale Group has a large long position in the German equity stock index DAX which has a volatility smile that slopes downward to the right. How will the change in methodology affect the estimate of expected shortfall (ES)?
- ES with the updated models will be larger than the old estimate.
- ES with the updated models will be smaller than the old estimate.
- ES will remain unchanged.
- Insufficient information to determine.
Explanation: A volatility smile is a common graphical shape that results from plotting the strike price and implied volatility of a group of options with the same expiration date. Since the volatility smile is downward sloping to the right, the implied distribution has a fatter left tail compared to the lognormal distribution of returns. This means that an extreme decrease in the DAX has a higher probability of occurrence under the implied distribution than the lognormal. The ES will therefore be larger when the methodology is modified.
