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After one year of working closely with a large var system and the underlying portfolio, I conclude that it is a rather good risk management tool.

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

by Pierre on Thu Feb 14th, 2008 at 01:19:54 PM EST
[ Parent ]
I understand what you're saying and that's the way it's supposed to work in theory, but then how do you explain all these 50-year events and 11- or 23-sigma moves, and so on?

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Thu Feb 21st, 2008 at 04:25:47 AM EST
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I don't explain these. The market is not log-normal. It may even follow a diffusion law where no moment exist and sigma is moot or infinite. That does not undermine the VaR concept. It does mean that the common MC VaR computed with a set of normally distributed shocks is an optimistic approximation of the market risk. It does not preclude the use of MC VaR with a set of Levy-distributed or fractal shocks (although practical calibration issues have so far precluded real-life adoption, banks R&D are still working on it, guys next door to me).

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

by Pierre on Thu Feb 21st, 2008 at 11:51:51 AM EST
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