jayjayjay1212

Risk Management, Or Risk Manipulation

I agree with this article in general. VaR, if used blindly, is indeed quite useless. However, I would like to add a few points, if I may, to give a few counter-arguments to the ones you made:

1. VaR models are ex-post models of risk. Everyone knows that you can't exclusively use the past to predict the future. However, the past can give indications of general patterns in asset returns over time, which can help. Because of that, most if not all firms use VaR in conjunction with many ex-ante (ie forward-looking) risk models. Those models normally integrate implied volatility curves, correlations and many other qualitative inputs to create a picture of the future risk portrait. Monte Carlo simulations are also widely used.

2. VaR models are not unique and differ in quality. Indeed, there is no definitive, objective and straightforward way to run your VaR model. The assumptions made are a major aspect of the end result. This means some are better than others, and that the quality of the management team will determine whether the VaR model is realistic or not. Obviously, companies with poorer VaR models (and poorer risk management in general) did much worse than the ones with better models. The better ones incorporated the real risks associated with options writing and selling credit default swaps. Poorer ones viewed them as steady gainers, where the losses fell in the ''unnormal'' part of the distribution. Knowledge of financial products along with common sense made it clear that CDS and options increase risk. Which leads to my next point:

3. The Board of directors of many firms lacked the knowledge and/or courage to question risk models and decisions made by management. The best example is with Lehman Brothers ; their board members were mostly from a non-financial background, were friends of the CEO, were advanced in age and inexperienced with the characteristics of the exotic products the firm was venturing into. Corporate governance was as much if not more to blame than risk management failures in Lehman's case.

Bottom line is VaR alone is a horrible way to manage risk. However, quality VaR models, in combination with ex-ante risk models, competent management teams and good corporate governance are all important factors in successfully managing the risks of a financial institution.