An Application of Extreme Value Theory for Measuring Financial Risk

Manfred Gilli, Evis Kellezi

Department of Econometrics, University of Geneva and FAME

Mirabaud & Cie, Boulevard du Theatre 3, 1204 Geneva, Switzerland

 Abstract

To determine the probability of rare and extreme events is an important issue in

the risk management of financial portfolios. Extreme Value Theory will help us to have
solid fundamentals needed for the statistical modelling of such events and the
computation of extreme risk measure. This paper focus in using extreme value theory to
compute tail risk measures in stock markets and also to help people who wanted a
successful in being a business man someday.

 Introduction

Financial risk is the type of specific risk that encompasses the many types
of risks related to a company's capital structure, financing and the finance industry.
These include risks involving financial transactions, such as company loans and
exposure to loan default. Risk is inherent in any business enterprise, and good risk
management is an essential aspect of running a successful business. A company's
management has varying levels of control in regard to risk. Some risks can be directly
managed; other risks are largely beyond the control of company management.
Sometimes, the best a company can do is try to anticipate possible risks, assess the
potential impact on the company's business and be prepared with a plan to react to
adverse events.This paper deals with the behavior of the tails of financial series. More
specifically, the focus is on the use of extreme value theory to compute tail risk
measures. Tail risk is a form of portfolio risk that arises when the possibility that an
investment will move more than three standard deviations from the mean is greater than
what is shown by a normal distribution. Tail risks include events that have a small
probability of occurring, and occur at both ends of a normal distribution curve.

 Methodology

- After the risk has been identified on its nature and type, assessment has taken
place i.e how big the risk is, the probability to occur and when it is going to happen,
then, the decision makers of the Organization or Firm may option on the following three
generic approaches:

• Hedging: Eliminate risk by selling into the market place through cash or spot market
transactions or through Forward, Future and Swap contracts.
• Diversification: This reduces risk by combining risks which are not perfectly correlated
to form a portfolio.

• Insurance: Risks are transferred from the buyer (Policyholder) to the seller i.e Insurer
(Peter Moles, 2013).

We first prove the boundedness theorem, which is a step in the proof of the extreme
value theorem. The basic steps involved in the proof of the extreme value theorem are:

1. Prove the boundedness theorem.

2. Find a sequence so that its image converges to the supremum of f.

3. Show that there exists a subsequence that converges to a point in the domain.

4. Use continuity to show that the image of the subsequence converges to the
supremum.

 Aknowledgement

-The researcher have a basis in writing the paper but they are pleased to have
an opportunity to make a reaserch.

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Submitted by :

Jhon Reyvin A. Garcia

Erille Jakehertz Erise