NYT - Joe Nocera - Risk Management
Indeed, Ethan Berman, the chief executive of RiskMetrics (and no relation to Gregg Berman), told me that one of VaR's flaws, which only became obvious in this crisis, is that it didn't measure liquidity risk -- and of course a liquidity crisis is exactly what we're in the middle of right now. One reason nobody seems to know how to deal with this kind of crisis is because nobody envisioned it. In a crisis, Brown, the risk manager at AQR, said, "you want to know who can kill you and whether or not they will and who you can kill if necessary. You need to have an emergency backup plan that assumes everyone is out to get you. In peacetime, you think about other people's intentions. In wartime, only their capabilities matter. VaR is a peacetime statistic."
In a crisis, Brown, the risk manager at AQR, said, "you want to know who can kill you and whether or not they will and who you can kill if necessary. You need to have an emergency backup plan that assumes everyone is out to get you. In peacetime, you think about other people's intentions. In wartime, only their capabilities matter. VaR is a peacetime statistic."
... the chief executive of RiskMetrics ... told me that one of VaR's flaws, which only became obvious in this crisis, is that it didn't measure liquidity risk -- and of course a liquidity crisis is exactly what we're in the middle of right now. One reason nobody seems to know how to deal with this kind of crisis is because nobody envisioned it.
European Tribune: Lazy Quote Diary: This Should Never Have Happened by Migeru on December 25th, 2007
The first of the books I want to quote from is John C. Hull's Options, Futures and Other Derivatives. The last (30th) chapter of the book is called Derivatives mishaps and what we can learn from them. Clearly what can be learned has not been learned because the book says the following:... Do not ignore liquidity risk Financial engineers usually base the pricing of exotic instruments and instruments that trade infrequently on the prices of actively traded instruments. ... This practice is not unreasonable. However, it is dangerous to assume that less-actively traded instruments can always be traded at close to their theoretical price. When financial markets experience a shock of one sort or another there is often a "flight to quality". Liquidity becomes very important to investors, and illiquid instruments often sell at a big discount to their theoretical values. Trading strategies that assume large volumes of relatively illiquid instruments can be sold at short notice at close to their theoretical values are dangerous. ...... it is all there in this chapter of the book everyone is supposed to have read! (Admittedly, this chapter was added to the 5th edition in 2003, but still...) ... The second book I want to quote from is Nassim Taleb's 1997 Dynamic Hedging: Managing Vanilla and Exotic Options which is nowadays marketed as "Taleb on Risk". This is a very technical practical book but it is also full of qualitative insight of a general nature. And it has been in print (and sold very well) for the past 10 years. So, unlike that last chapter of Hull which was only added in 2003, veteran risk managers cannot claim that they were not aware of the stuff in Taleb's book. And yet... ... Liquidity and Risk Management It cannot be stressed enough that liquidity is the most serious risk management problem. A substantial part of unforeseen losses is due either to market jumps caused by illiquidity or to liquidation costs that substantially move the market against one's position. Liquidation costs tend to be usually underestimated since operators usually "fade" when someone is forced into a market action
... Do not ignore liquidity risk Financial engineers usually base the pricing of exotic instruments and instruments that trade infrequently on the prices of actively traded instruments. ... This practice is not unreasonable. However, it is dangerous to assume that less-actively traded instruments can always be traded at close to their theoretical price. When financial markets experience a shock of one sort or another there is often a "flight to quality". Liquidity becomes very important to investors, and illiquid instruments often sell at a big discount to their theoretical values. Trading strategies that assume large volumes of relatively illiquid instruments can be sold at short notice at close to their theoretical values are dangerous. ...
Do not ignore liquidity risk
Financial engineers usually base the pricing of exotic instruments and instruments that trade infrequently on the prices of actively traded instruments. ...
This practice is not unreasonable. However, it is dangerous to assume that less-actively traded instruments can always be traded at close to their theoretical price. When financial markets experience a shock of one sort or another there is often a "flight to quality". Liquidity becomes very important to investors, and illiquid instruments often sell at a big discount to their theoretical values. Trading strategies that assume large volumes of relatively illiquid instruments can be sold at short notice at close to their theoretical values are dangerous.
...
The second book I want to quote from is Nassim Taleb's 1997 Dynamic Hedging: Managing Vanilla and Exotic Options which is nowadays marketed as "Taleb on Risk". This is a very technical practical book but it is also full of qualitative insight of a general nature. And it has been in print (and sold very well) for the past 10 years. So, unlike that last chapter of Hull which was only added in 2003, veteran risk managers cannot claim that they were not aware of the stuff in Taleb's book. And yet...
Liquidity and Risk Management It cannot be stressed enough that liquidity is the most serious risk management problem. A substantial part of unforeseen losses is due either to market jumps caused by illiquidity or to liquidation costs that substantially move the market against one's position. Liquidation costs tend to be usually underestimated since operators usually "fade" when someone is forced into a market action
It cannot be stressed enough that liquidity is the most serious risk management problem. A substantial part of unforeseen losses is due either to market jumps caused by illiquidity or to liquidation costs that substantially move the market against one's position. Liquidation costs tend to be usually underestimated since operators usually "fade" when someone is forced into a market action
Not to speak of the fact that both books contain criticism of VaR (stronger and more pointed in the case of Taleb). Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
As they wrote elsewhere the problem with VaR is that 99% of the time that's the most you can lose, but ever so occasonally it's the least you will lose. So you'd better have other analysis going on and the point being that, most of the time, VaR was all they had.
btw taleb gets a starring role in the article keep to the Fen Causeway
naked capitalism: Woefully Misleading Piece on Value at Risk in New York Times
By neglecting to expose this basic issue, the piece comes off as duelling experts, and with the noisiest critic of VaR, Nassim Nicolas Taleb, dismissive and not prone to explanation, the defenders get far more air time and come off sounding far more reasonable. It similarly does not occur to Nocera to question the "one size fits all" approach to VaR. The same normal distribution is assumed for all asset types, when as we noted earlier, different types of investments exhibit different types of skewness. The fact that VaR allows for comparisons across investment types via force-fitting gets nary a mention.
Shouldn't someone tell the markets that as long as you do a little statistical diddling VaR works just fine?
The last year has been a lot of fuss over nothing, clearly.
