Managing extreme risks in tranquil and volatile markets using conditional extreme value theory

Abstract

Financial risk management typically deals with low-probability events in the tails of asset price distributions. To capture the behavior of these tails, one should therefore rely on models that explicitly focus on the tails. Extreme value theory (EVT)-based models do exactly that, and in this paper, we apply both unconditional and conditional EVT models to the management of extreme market risks in stock markets. We find conditional EVT models to give particularly accurate Value-at-Risk (VaR) measures, and a comparison with traditional (Generalized ARCH (GARCH)) approaches to calculate VaR demonstrates EVT as being the superior approach both for standard and more extreme VaR quantiles.