The Value-at-Risk Below is a presentation of a risk management method that, like portfolio insurance, can only work if a small number of people are using it. It is a paradox ... that states that it can only work (and succeed) if it is unsuccessful
Below is a presentation of a risk management method that, like portfolio insurance, can only work if a small number of people are using it. It is a paradox ... that states that it can only work (and succeed) if it is unsuccessful
The VaR can present some useful short-term hedging tools for traders... However, it led to seriously disputed applications by risk management firms that led (perhaps innocently) their customers to believe they possessed tools to summarize the overall market risks for a position, a unit, a department, or an entire firm, in one simplified numerical exposure, without standard error.
The idea of disclosing the overall exposure as one simple quantity appeals to most corporate board members and regulators, many of whom are uninitiated into the nuances and complexities of financial market risks. They can easily be impressed by the "scientific" tools used. ... Critics of VaR (including the author) argue that simplification could result in such distortions as to nullify the value of the measurement. Furthermore, it can lead to charlatanism. Lulling an innocent investor or business manager into a false sense of securitycould be a serious breach of faith. ... In brief, it cannot be used to say "Within 99.7% (or within 90% or something of the sort), you are not expected to lose in the next month more than 1 million dollars". The innocent treasurer or company official would believe himself to be listening to a scientific statistic similar to statistics on airplane crashes. It could, however, be used to say: "You are expected to lose no more than 100,000 dollars within the next two hours with a 66% accuracy, provided that you do not try to liquidate your position and the other similar firms do not have the same portfolio."
... Critics of VaR (including the author) argue that simplification could result in such distortions as to nullify the value of the measurement. Furthermore, it can lead to charlatanism. Lulling an innocent investor or business manager into a false sense of securitycould be a serious breach of faith. ...
In brief, it cannot be used to say "Within 99.7% (or within 90% or something of the sort), you are not expected to lose in the next month more than 1 million dollars". The innocent treasurer or company official would believe himself to be listening to a scientific statistic similar to statistics on airplane crashes. It could, however, be used to say: "You are expected to lose no more than 100,000 dollars within the next two hours with a 66% accuracy, provided that you do not try to liquidate your position and the other similar firms do not have the same portfolio."
The VaR provides an admirable short-term hedging tool but is by no means a risk management device
the fact that such a system became a benchmark would cause a snowball effect. ... In a schematic world of a small numner of homogeneous leveraged players, everyone would end up with close to the same portfolio constitution and weights owing to the diversification scheme (optimal portfolio) ... They would all ivest more lulled with the knowledge of being comfortably diversified asthey were properly taught by the risk management consultant. ... Assume that the price of A went down. Assume that the volatility of A increased. To maintain a constant VaR ... the operator would have to sell some stocks of B and C. The quantities, though small, would be enough to push prices lower and make operators race each other to the state of near-bankruptcy. ... An interesting parameter in hedges is that they only work when they are not identified as hedges by the multitude. If most other similar institutions needed to act in a similar manner in similar circumstances, there would be a dynamical system traders would need to account for.
... In a schematic world of a small numner of homogeneous leveraged players, everyone would end up with close to the same portfolio constitution and weights owing to the diversification scheme (optimal portfolio) ... They would all ivest more lulled with the knowledge of being comfortably diversified asthey were properly taught by the risk management consultant.
...
Assume that the price of A went down. Assume that the volatility of A increased. To maintain a constant VaR ... the operator would have to sell some stocks of B and C. The quantities, though small, would be enough to push prices lower and make operators race each other to the state of near-bankruptcy. ... An interesting parameter in hedges is that they only work when they are not identified as hedges by the multitude. If most other similar institutions needed to act in a similar manner in similar circumstances, there would be a dynamical system traders would need to account for.
The market will follow the path that will thwart the higher number of possible hedgers.
Somehow, this strikes me as a fact that should not be surprising. After all, if the market works, and everyone has access to the same information, future value should already be incorporated into share price - so in order to do better than betting on horses, you need to be better at predicting the future value than the other players.
So, are these people betting on horses, or do they think everyone else are suckers, or have I missed something in my analysis?
- Jake If you only spend 20 minutes of the rest of your life on economics, go spend them here.
What I hear you saying is that they assume that stuff happening on the other side of the market is only weakly correlated with the stuff that happens to their portfolio. And that assumption turned out to be Very Wrong.
Signed: Bill Gates
That is, when it is properly implemented (full MC) and with a sensible model. We only got a few backtesting exceptions above the norm (when major US banks had dozens since the beginning of the crisis).
VaR (and CVaR ideally) does tell you that you are at risk, and how much risk, it does not tell you how to cut that risk without materializing the loss if your market isn't deep enough - VaR analyzes market risk, not credit risk or liquidity risk. Confusions on the aim of the indicator are due to over-hyping and marketing by gurus and software vendors.
And lastly, VaR applies to trading portfolios, not to investment portfolios. And all the significant losses in this crisis happened in banking portfolios, except for the Kerviel case. VaR isn't even computed on banking portfolios (buy and hold, whether direct or indirect through SIV, of crappy assets like CDO's and RMBS, which are meant to take direct exposure and are not hedged because they are not supposed to default, hedge not being available on the required notionals anyway, or if "available", it's bogus, see monolines). Pierre
It does degrade the accuracy of VaR through prices and/or greeks used in VaR and derived by means of log-normal resolution of stochastic equations, or MC diffusions. For equities, volatility smiles etc are some sort of built-in-pricer fixes, though ugly. Younger derivatives markets (CDS anyone ?) may have a bigger accuracy problem. Although nothing impossible to overcome.
My feeling is, these present short-comings are (quite) well understood in (some) (french) risk management. The US do seem to have a huge problem with it. Presently writing an article on this, but it will be company-copyrighted material ("you address the shortcomings faster if you buy my consulting", no shit). Pierre
