Background on Extreme Value Theory

 In risk management, a risk manager/officer is primarily concerned with distribution of losses

that a low in frequency and of high severity.
 Such losses are mostly found at the upper tail of the distribution.
 However, most risk modelling strategies/methods focus on accurately representing the body
of the distribution, and less focus on the distribution of the tail.

Example

 It is assumed that returns are normally or log-normally distributed and little attention is paid
to the distribution of the extreme returns.
 The danger is that in large market moves we can suffer very large losses.

Possible response

 Simulate the changes in the value of our portfolio under hypothesized extreme market
conditions (stress tests and scenario analysis).
 Useful but limited because we cannot explore all possible scenarios.

What is Extreme Value Theory?

unncry
The tail distribution is used to determine capital and shortfall risk constraints for optimizing
strategies.

ETV is a technique for increasing the accuracy with which to model the probability of large values in
the tail distribution.

EVT is devoted to the modelling and estimating the behaviour of rare events.