Financial institutions need to take volatility clustering into account:
1. To avoid taking on an undesirable level of risk
2. To know the right level of capital they need to hold
3. To meet regulatory requirements
4. To account for mean reversion in returns
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Correct Answer:
B
Volatility clustering leads to levels of current volatility that can be significantly different from long run averages. When volatility is running high, institutions need to shed risk, and when it is running low, they can afford to increase returns by taking on more risk for a given amount of capital. An institution's response to changes in volatility can be either to adjust risk, or capital, or both. Accounting for volatility clustering helps institutions manage their risk and capital and therefore statements I and II are correct.
Regulatory requirements do not require volatility clustering to be taken into account (at least not yet). Therefore statement III is not correct, and neither is IV which is completely unrelated to volatility clustering.
