Joe Nocera on Value at Risk: Not as Useless as Advertised, But...

In Sunday’s New York Times Magazine, Joe Nocera does a nice job summarizing the pros and cons of quantified risk measures such as Value at Risk, and sticking up for them against attacks from the black-swan brigade.

But he notes that risk managers’ fixation with VaR has had some unintended consequences that weren’t so great, such as, apparently, increasing the casino-like nature of the CDS market:

[I]t turned out that VaR could be gamed. That is what happened when banks began reporting their VaRs. To motivate managers, the banks began to compensate them not just for making big profits but also for making profits with low risks. That sounds good in principle, but managers began to manipulate the VaR by loading up on what Guldimann calls “asymmetric risk positions.” These are products or contracts that, in general, generate small gains and very rarely have losses. But when they do have losses, they are huge. These positions made a manager’s VaR look good because VaR ignored the slim likelihood of giant losses, which could only come about in the event of a true catastrophe. A good example was a credit-default swap, which is essentially insurance that a company won’t default. The gains made from selling credit-default swaps are small and steady — and the chance of ever having to pay off that insurance was assumed to be minuscule. It was outside the 99 percent probability, so it didn’t show up in the VaR number. People didn’t see the size of those hidden positions lurking in that 1 percent that VaR didn’t measure. [Emph. added]

Oy. Slavish fixation on a single number, in any pursuit, is rarely a good idea. . .

Comments

[Till Guldimann:]

You may want to follow this link [ sungard.com/tillguldim... ] which points to a document which explains the gaming in more detail and explores why the financial system has become fundamentally unstable.

Jan 06 06:54 PM

[Robert H. H...:]

Guldimann's paper is well worth reading and is a nice antidote to the "VaR Models Made Me Do It!" theme that pervades the Nocera article (which is also worth reading).

It should be noted that ANY incentive compensation system can and, with enough dollars at play, WILL be "gamed". The fact that traders consciously or unconsciously figured out that they could stuff risk into the fat tails without being charged for that risk is a new twist on an ancient practice.

Jan 29 02:11 PM