If I find an indicator (e.g. an earthquake happening) that is almost always followed by a VaR breach the next day. That means the probability of breach conditional on the indicator is too
(high/low). I should adjust the VaR
(higher/lower) the next time I see the indicator.

Question

If I find an indicator (e.g. an earthquake happening) that is almost always followed by a VaR breach the next day. That means the probability of breach conditional on the indicator is too 
 (high/low). I should adjust the VaR 
 (higher/lower) the next time I see the indicator.

BlackTom AI · Accepted Answer

In this scenario, you observe a link between an indicator (like an earthquake event) and a subsequent Value-at-Risk (VaR) breach the next day. If this indicator is almost always followed by a VaR breach, the conditional probability of a breach given the indicator P(breach | indicator) is too high relative to the VaR target. Therefore, the first blank should be filled with 'high' to reflect that the probability is elevated.

Next, because the indicator tends to precede breaches, the estimated risk that the VaR threshold will be breached on a future instance conditioned on seeing the indicator is also elevated. To be more conservative and to maintain the stated confidence level for VaR, you would increase the VaR for the next period when you observe the indicator. Thus the second blank should be filled with 'higher' to indicate raising the VaR level.

To make this concrete, consider the logic of risk controls: if the event signal suggests more frequent or larger losses than the current VaR accounts for, you must adjust the risk guardrails upward. Conversely, if the indicator were rarely followed by breaches (low P(breach | indicator)), you would lower the VaR or refrain from increasing it. This helps avoid systematically underestimating risk when the signal is predictive, and avoids overreacting when it is not.

In summary, the intuitive reading is that the probability is high, and the VaR should be higher the next time the indicator is seen, to preserve the integrity of the risk measure and maintain the desired safety margin.

BU.230.730.53.SP25 Final Exam- Requires Respondus LockDown Browser

If I find an indicator (e.g. an earthquake happening) that is almost always followed by a VaR breach the next day. That means the probability of breach conditional on the indicator is too (high/low). I should adjust the VaR (higher/lower) the next time I see the indicator.

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