W

e now turn to more advanced risk models. First, we consider univariate risk

models. Multivariate models are presented in the next chapter.

This chapter covers improvements to traditional risk models. In practice, the

implementation of risk models for large institutions involves many shortcuts, sim-

plifications, and judgment calls. The role of the risk manager is to design a system

that provides a reasonable approximation to the risk of the portfolio with accept-

able speed and cost. The question is how to judge whether accuracy is reasonable.

This is why risk models must always be complemented by a backtesting proce-

dure. This involves systematically comparing the risk forecast with the subsequent

outcome. The framework for backtesting is presented in Section 15.1.

Next, we examine a method to improve the estimation of the tail quantile

beyond the traditional historical-simulation and delta-normal methods, which

can be defined as nonparametric and parametric, respectively. Section 15.2 turns

to extreme value theory (EVT), which can be used to fit an analytical distribution

to the left tail. This method, which can be described as nonparametric, gives more

precise value at risk (VAR) estimates. In addition, the analytical function can be

used to extrapolate VAR to other confidence levels.