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Fat Tails and Extreme Events [31]

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Bullet points include: Even a model with good back-test properties may fail to model future risks effectively. Because the past is not necessarily a good guide to the future. Markets are not like precisely defined external physical systems whose actions are perfectly predictable. Magnitude of impact of a given scenario usually (relatively) easy to calculate. The challenge is how to identify the scenario’s likelihood. Stress testing focuses more on magnitude, and what makes the scenario adverse, and pays less attention to likelihood

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