On time-scaling of risk and the square–root–of–time rule

Many financial applications, such as risk analysis and derivatives pricing, depend on time scaling of risk. A common method for this purpose, though only correct when returns are iid normal, is the square–root–of–time rule where an estimated quantile of a return distribution is scaled to a lower frequency by the square-root of the time horizon. The aim of this paper is to examine time scaling of risk when returns follow a jump diffusion process. It is argued that a jump diffusion is well-suited for the modeling of systemic risk, which is the raison d’etre of the Basel capital adequacy proposals. We demonstrate that the square–root–of–time rule leads to a systematic underestimation of risk, whereby the degree of underestimation worsens with the time horizon, the jump intensity and the confidence level. As a result, even if the square–root–of–time rule has widespread applications in the Basel Accords, it fails to address the objective of the Accords.

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http://eprints.lse.ac.uk/24827/1/dp439.pdf