Pitfalls and Opportunities in the Use of Extreme Value Theory in Risk Management

Extreme value theory (EVT) holds promise for advancing the assessment and management of extreme financial risks. Recent literature suggests that the application of EVT generally results in more precise estimates of extreme quantiles and tail probabilities of financial asset returns. This article assesses EVT from the perspective of financial risk management. The authors believe that the recent optimism regarding EVT may be appropriate but exaggerated, and that much of its potential remains latent. They support their claim by describing various pitfalls associated with the current use of EVT techniques, and illustrate how these can be avoided. In conclusion, the article defines several specific research directions that may further the practical and effective application of EVT to risk management.