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I'm tempted to supplement my Lazy Quote Diary: This Should Never Have Happened with a couple of quotations on "Value at Risk" from Taleb's Dynamic Hedging (1997). His basic thrust is that VaR is a rule of thumb used by traders to quickly estimate the proper size of a hedge for a single instrument, and that it should not be taken as a measure of risk for whole portfolios, which is precisely what has happened (Basel II has made VaR the cornerstone of risk management in banking). In fact, there are good mathematical reasons not to use VaR for portfolios.
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

"Porfolio insurance" was a financial product which caused a liquidity hole in 1987. Essentially, the way this insurance was constructed it caused larger positions to be taken in stocks than would otherwise have been, when  people tried to get out of the positions as prices started going the wrong way it snowballed out of control.
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.
So VaR was already "seriously disputed" as a risk measure before 1997.
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."

After discussing various shortcomings of VaR when large deviations are involved, he concludes
The VaR provides an admirable short-term hedging tool but is by no means a risk management device
Under "dangers of generalized use" he discusses how
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.

And then the punchline
The market will follow the path that will thwart the higher number of possible hedgers.

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Wed Feb 13th, 2008 at 05:23:18 PM EST
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