Chartered Financial Analyst (CFA) Practice Exam Level 2

What limitation does Historical Value at Risk (HVAR) have?

1. Assumes normal return distribution

2. Requires large historical database

3. Adapts quickly to realtime changes

4. Performs sensitivity analysis easily

The correct answer is: Requires large historical database

The limitation of Historical Value at Risk (HVAR) primarily lies in its requirement for a large historical database. HVAR relies on the assumption that past market data can be used to predict future risk. To effectively assess potential losses, it must analyze a substantial amount of historical data to ensure that its risk estimates have statistical significance and reliability. A limited dataset can lead to inaccurate estimates, as it may not encompass various market conditions or extreme events (tail risks) that could occur in the future. Essentially, if an analyst does not have years of relevant historical data, the HVAR calculation may produce misleading results, making it less effective in guiding risk management decisions. While options suggesting the assumptions of normal distribution or quick adaptation to real-time changes touch upon other aspects of risk measurement, they do not directly address the inherent challenge posed by the necessity of a sufficient historical dataset for accurate assessments. Similarly, sensitivity analysis is more typically associated with other methods rather than HVAR specifically. Thus, the need for a robust and extensive historical database is a fundamental limitation of HVAR.