8. Market Risk Models

Question 1

Describe 4 shortcomings of the ILN model

Answer 1

1. The ILN has constant volatility, and we know that the volatility in the market is varying from periods to periods (in clumps).
2. Log-returns are assumed to be independent, positive returns and negative returns will generally be grouped together.
3. Log-returns are assumed to be symmetric, but negative spikes are much more common than positive spikes.
4. The ILN is bad at replicating crisis’s that periodically happen (no leverage effect).

Question 2

Describe the ILN model

Question 3

Describe the GARCH model

Question 4

Describe the Regime-switching model

Question 5

What are advantages of the GARCH model over the ILN model?