Practical Methods of Financial Engineering and Risk Management

CHAPTER 8

Power Laws and Extreme Value Theory

The commonly used risk measures of VaR and CVaR almost always deal with the tails of a distribution. A risk manager often needs to report the 99% and 99.9% VaR and CVaR. He or she rarely needs to find the 60% VaR or CVaR. This indicates that much of the full distribution is ignored for risk purposes, even though a lot of effort may have gone into creating the whole distribution of future gains and losses of some asset. This prompts the question, “Why not simply have a methodology to create only the tail of a distribution and ignore everything else?” Extreme value theory (EVT) is a field of probability ...