The power law

In the third of a series explaining recent developments in risk management and derivatives pricing, John Hull considers the power law as a means of estimating the extreme tail of the loss distribution

Risk managers often want levels of confidence as high as 99%, 99.9% or even 99.97% when calculating value-at-risk. This requires knowledge of the extreme tail of the loss distribution. The trouble is, it's not usually possible to collect enough data to accurately estimate the tail directly. The power law is a way of overcoming this problem.

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