Financial Pitfalls and Opportunities in the

Institutions Use of Extreme Value Theory in

Center Risk Management

by
Francis X. Diebold
Til Schuermann
John D. Stroughair

98-10
 THE WHARTON FINANCIAL INSTITUTIONS CENTER

The Wharton Financial Institutions Center provides a multi-disciplinary research approach to

the problems and opportunities facing the financial services industry in its search for
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Director

The Working Paper Series is made possible by a generous

grant from the Alfred P. Sloan Foundation
 1
Pitfalls and Opportunities in the Use of Extreme Value Theory in Risk Management

March 1998

Abstract: Recent literature has trumpeted the claim that extreme value theory (EVT) holds
promise for accurate estimation of extreme quantiles and tail probabilities of financial asset
returns, and hence holds promise for advances in the management of extreme financial risks.
Our view, based on a disinterested assessment of EVT from the vantage point of financial risk
management, is that the recent optimism is partly appropriate but also partly exaggerated, and
that at any rate much of the potential of EVT remains latent. We substantiate this claim by
sketching a number of pitfalls associated with use of EVT techniques. More constructively,
we show how certain of the pitfalls can be avoided, and we sketch a number of explicit
research directions that will help the potential of EVT to be realized.

1
Francis X. Diebold is at the University of Pennsylvania and Oliver Wyman Institute, 3718 Locust Walk,
Philadelphia, PA 19104-6297, USA. E-mail: fdiebold@mail.sas.upenn.edu.

Til Schuermann and John D. Stroughair are at Oliver, Wyman and Company, 666 Fifth Avenue, New York, NY
10103, USA. E-mail: tschuermann@owc.com, jstroughair@owc.com.