Risks of Risk Management

[aaron]

[i]<< I'm still struggling with this - it just feels a bit too much like these terrorism alert scales. If you get to the red level, does it mean you should stay home? There are market volatility indices - ok, the sailing is getting rougher, but what is the actionable thing here? Find a new business? In an aggregated form, does it really tell management that the risks of being in their current portfolio of businesses has gone up? I mean, that much can be had from the morning news. I really don't see how it would lead to a different strategy than meeting with the desk heads and working out a plan to change the course of the battleship, unless you don't trust the desk heads to give you an unbiased view of their business. Is that what it's all about? >>[/i]



VaR is not actionable. An actionable risk measure would depend on asset class and strategy, and thus could not aggregate. Also "actionable" means different things to senior management and traders, so a single measure can't be actionable to both groups. Another of the big advantages of VaR is it makes sense at the business decision-making level and the strategic level.



If VaR is the same as yesterday it doesn't mean everything's okay, but if thing's aren't okay, there's a decent chance you'll see it reflected in VaR. If VaR is a small fraction of available capital it doesn't mean your business is safe, but if your business is at high risk, there's a decent chance it will show up in a high VaR to capital ratio. So VaR is valuable, especially in combination with things likely to catch the things that VaR misses. More complicated measures designed to catch everything end up taking too much time and too high IQ to check every day.



Say you have a $10 million firmwide VaR limit against $50 million of capital, and VaR is typically between $3 million and $6 million. It was $7 million three days ago, since then it's gone up to $7.5 million, $8.5 million and (today) $13 million. As CEO, what do you do?



First, you get alert. You make sure you're paying attention to the news, and all those little reports that go across your desk. You find out where your senior managers are. You look to see if there are any stresses coming up.



Next, you drill down. Was the VaR increase driven by position changes or market changes or both? Which divisions caused it (or was it changes in correlation among divisions)? How's P&L done lately (are people doubling up after losses or increasing bets because they're on hot streaks?)?



Say at the end of this analysis you find that credit markets have gotten more volatile in ways your traders anticipated, so you've made money. Absolute positions are rising at the same time volatility is going up, so a careful analysis of the credit business (not based on VaR, that was just the thing that alterted you to look in the first place) tells you there is a signficant chance of bankrupting the firm if the current bets are wrong.



Now you have decisions to make. VaR won't tell you want to do. But it did alert you and show you where to concentrate. Without VaR, you might still be working on the liquor brands to be served in the corporate jet.

[sfca]

Perhaps one of the greatest risks of risk management is getting cornered into appearing to be an apologist for VAR.