Chartered Financial Analyst (CFA) Practice Exam Level 2

What is a fundamental assumption of Historical Value at Risk (HVAR) regarding future and past returns?

1. Future returns will be more volatile than past returns

2. Future and past returns will not exhibit any correlation

3. Past and future returns are assumed to be similar

4. The model adapts to changes in market conditions

The correct answer is: Past and future returns are assumed to be similar

The correctness of this answer lies in the fundamental concept of Historical Value at Risk (HVAR), which operates on the premise that the distribution of past returns is reflective of future risks. HVAR utilizes historical data to predict potential losses in value over a specified time frame, assuming that the patterns observed in the past will continue into the future. This assumption implies that investors can rely on historical returns to gauge the potential for future returns, hence the belief that past and future returns are similar. This approach essentially hinges on the idea that the market dynamics and behaviors that influenced past returns will remain consistent, allowing for a reliable estimate of risk based on historical performance. While this assumption has its limitations, particularly during periods of significant market shifts, it serves as a foundational concept underpinning HVAR models. In contrast, the other options suggest relationships or conditions that are contrary to the fundamental principle of HVAR. For instance, asserting that future returns will be more volatile than past returns or that past and future returns would not exhibit correlation introduces variables that HVAR does not account for since it primarily relies on historical data without considering future volatility trends or potential shifts in correlation. Similarly, stating that the model adapts to changes in market conditions suggests a level of dynamism not inherent