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Quantifying Volatility in VAR Model: Fat Tails

  • There are two explanations for the Fat Tails
    • Conditional Mean: Mean changing over the period of time
    • Conditional Volatility: Volatility changing over the period of time
  • Market conditions may cause the mean and variances to change over the period of time, which leads to
  • fat-tailed distributions

  • The fat-tailed unconditional distribution can be broken down into two conditional distributions, either with similar means and different variances or similar variances and different means.
  • Many a times when we observe marked differences between the estimated and actual volatilities, it’s a result of regime switching which means that the average volatility in the market has now changed too much when compared to the previous estimate

Risk Management is all about understanding tails of distribution



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