Comments on: Risk Management for Beginners http://baselinescenario.com/2009/01/04/risk-management-var/ What happened to the global economy and what we can do about it Sat, 21 Nov 2009 02:32:50 +0000 http://wordpress.com/ hourly 1 By: Capire la crisi « a spotless mind http://baselinescenario.com/2009/01/04/risk-management-var/#comment-3110 Capire la crisi « a spotless mind Sat, 31 Jan 2009 08:20:44 +0000 http://baselinescenario.com/?p=1833#comment-3110 [...] Il risk management fa male  [...] [...] Il risk management fa male  [...]

]]> By: regionswork http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2943 regionswork Sun, 25 Jan 2009 19:08:24 +0000 http://baselinescenario.com/?p=1833#comment-2943 I'm glad this discussion has continued. I have been involved in trend analysis for planning over 35 years. In no circumstance would two years of demographic, economic or environmental data give a usable trend. In that time frame it would barely be possible to see a spike. For traders, small moves, can generate opportunity for profit, but that alone should not validate short term data sets The fact that everyone is doing it, sub-prime lending in this case, increased the overall magnitude of risk in the system and made it possible for the triggering event to be smaller. The down feather of a Black Swan set off the dominoes. I believe it was the Fed fighting inflation and increasing the bank rate that triggered the ARMs and tipped so many households into foreclosure. The economy had not grown enough for those individuals to cover the risk they were allowed to take/encouraged to take, particularly if they'd taken an ARM over a fixed rate - making more money for the broker. Increasing foreclosures were seen by those in the trenches on Wall Street, communicated to Jim Cramer and, eventually, led to his rant. The seriousness of a family not being able to meet the mortgage payment, can't really be reflected in numbers and obviously wasn't when "the brains" were doing their math. If those that created the formulas never had the experience - they could not relate to it. Probability has to be related to the current environment and the risk formulas can't handle that. In the present, the probability of there being a female president of the U.S. is very high, as is the probability of there being males other than white. Gender or race will not disqualify competent individuals. As for technologically advanced intelligent life, the probability may be of them finding us. We've sent out signals, but would they respond without careful investigation of this noisy planet? As irrational as we are, we might be unwelcome in the neighborhood. Finance apparently has lost its sense of the long term. Are we at a point where there is only trading, no investing? When any asset can hold within itself a hot potato, how will trust be restored? Making money with money has hit a wall. I’m glad this discussion has continued. I have been involved in trend analysis for planning over 35 years. In no circumstance would two years of demographic, economic or environmental data give a usable trend. In that time frame it would barely be possible to see a spike. For traders, small moves, can generate opportunity for profit, but that alone should not validate short term data sets The fact that everyone is doing it, sub-prime lending in this case, increased the overall magnitude of risk in the system and made it possible for the triggering event to be smaller. The down feather of a Black Swan set off the dominoes. I believe it was the Fed fighting inflation and increasing the bank rate that triggered the ARMs and tipped so many households into foreclosure. The economy had not grown enough for those individuals to cover the risk they were allowed to take/encouraged to take, particularly if they’d taken an ARM over a fixed rate – making more money for the broker. Increasing foreclosures were seen by those in the trenches on Wall Street, communicated to Jim Cramer and, eventually, led to his rant. The seriousness of a family not being able to meet the mortgage payment, can’t really be reflected in numbers and obviously wasn’t when “the brains” were doing their math. If those that created the formulas never had the experience – they could not relate to it. Probability has to be related to the current environment and the risk formulas can’t handle that. In the present, the probability of there being a female president of the U.S. is very high, as is the probability of there being males other than white. Gender or race will not disqualify competent individuals. As for technologically advanced intelligent life, the probability may be of them finding us. We’ve sent out signals, but would they respond without careful investigation of this noisy planet? As irrational as we are, we might be unwelcome in the neighborhood. Finance apparently has lost its sense of the long term. Are we at a point where there is only trading, no investing? When any asset can hold within itself a hot potato, how will trust be restored? Making money with money has hit a wall.

]]> By: C. http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2897 C. Fri, 23 Jan 2009 22:40:41 +0000 http://baselinescenario.com/?p=1833#comment-2897 "@ Independent Accountant - “Coin toss is not risk, only uncertainty” - so what is risk if not for uncertainty? Suppose you had bet a million dollars on the outcome of a coin toss? Is that not risk?" @Greg --- No, it's not. In common speech, "risk" has the meaning you ascribe --- an event whose outcome is as yet unknown but may be negative. Risk v. Uncertainty in an investing or economics context have distinct meanings. A risk, investing wise, is the known probability of an event, particularly an undesired event. In the coin toss example, there are only two possible outcomes, heads or tails. Whichever result I bet on, there is a 50/50 chance I might be wrong --- that's a risk. The bad thing could happen but I know the chances of it happenning, and I can plan around them, and more importantly in an investing context, I can put a price on how much I'd be willing to pay for taking on a certain amount of risk. An investor with a $1 billion to invest, might be willing to risk $1 million on a coin flip, as that sum is only .1% of their total assets. And investor with $2 million would probably not be willing to take on such a risk. Uncertainty, however, that's a whole 'nother thing. Uncertainty is a situation where the likelyhood of a given outcome is unknown and cannot be determined. That's more like betting a million on whether or not humans will ever find intelligent life on another planet. We just don't know enough about what the rest of the universe is like to figure out precisely what the true chances are of such a thing happening. These two things can shade into each other --- For instance a million-dollar bet on whether or not a woman will ever become president of the United States. In the past hundred years, it would seem clear that the chances of such a thing have clearly changed, and we might be able to quantify them somewhat by looking at other countries where there have been female heads of state, the circumstances surrounding their elections, the demographics and political systems of the societies involved, etc. But there's still a lot of unknown unknowns there, a lot of uncertainty. The real problem is when you think you're dealing with risk and it turns out you're dealing with uncertainty.... “@ Independent Accountant – “Coin toss is not risk, only uncertainty” – so what is risk if not for uncertainty? Suppose you had bet a million dollars on the outcome of a coin toss? Is that not risk?”

@Greg — No, it’s not. In common speech, “risk” has the meaning you ascribe — an event whose outcome is as yet unknown but may be negative. Risk v. Uncertainty in an investing or economics context have distinct meanings.

A risk, investing wise, is the known probability of an event, particularly an undesired event. In the coin toss example, there are only two possible outcomes, heads or tails. Whichever result I bet on, there is a 50/50 chance I might be wrong — that’s a risk.

The bad thing could happen but I know the chances of it happenning, and I can plan around them, and more importantly in an investing context, I can put a price on how much I’d be willing to pay for taking on a certain amount of risk. An investor with a $1 billion to invest, might be willing to risk $1 million on a coin flip, as that sum is only .1% of their total assets. And investor with $2 million would probably not be willing to take on such a risk.

Uncertainty, however, that’s a whole ‘nother thing. Uncertainty is a situation where the likelyhood of a given outcome is unknown and cannot be determined. That’s more like betting a million on whether or not humans will ever find intelligent life on another planet. We just don’t know enough about what the rest of the universe is like to figure out precisely what the true chances are of such a thing happening.

These two things can shade into each other — For instance a million-dollar bet on whether or not a woman will ever become president of the United States. In the past hundred years, it would seem clear that the chances of such a thing have clearly changed, and we might be able to quantify them somewhat by looking at other countries where there have been female heads of state, the circumstances surrounding their elections, the demographics and political systems of the societies involved, etc. But there’s still a lot of unknown unknowns there, a lot of uncertainty.

The real problem is when you think you’re dealing with risk and it turns out you’re dealing with uncertainty….

]]> By: Eric L. Prentis http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2777 Eric L. Prentis Mon, 19 Jan 2009 22:42:31 +0000 http://baselinescenario.com/?p=1833#comment-2777 Financial risk (VaR) model flaws go much deeper than just the shape of asset price distributions because they rely on the Efficient Market Hypothesis (EMH) to model markets as efficient, always in equilibrium and self correcting where security prices simply react to random news releases. The EMH models day-to-day security price movements as “independent random variables” where purchase or sale is a “zero net present value transaction,” resulting in neither the buyer nor seller having an advantage. Consequently, security trading is modeled like casino gambling where price volatility determines risk assessment. The EMH concludes that because prices always fairly reflect intrinsic value and it is impossible to know what markets are going to do, consequently, fundamental analysis isn’t cost effective. The EMH model is both naïve and specious, i.e., it relies on incorrect premises and, therefore, cannot correctly model market risk. A discussion follows. Markets are not always in equilibrium nor self correcting but rather are a discounting mechanism, i.e., professional traders look ahead and bid prices either up or down prior to earnings and/or economic news announcements; that is why prices can go up on bad news and down on good news. Security prices from day-to-day seem random, however, portfolio diversification cancels out unsystematic risk, therefore, markets as a whole only have systematic risk. Using a diversified market portfolio, monthly rather than daily data, trend lines and conditional probabilities based on fundamental analysis correctly models systemic market risk; thereby disqualifying the flawed EMH’s reliance on securities’ price frequency and the use of price volatility as a proxy for portfolio risk which is not sufficient information when hedging positions. (Eric L. Prentis is the author of “The Astute Investor” and “The Astute Speculator,” www.theastuteinvestor.net ) Financial risk (VaR) model flaws go much deeper than just the shape of asset price distributions because they rely on the Efficient Market Hypothesis (EMH) to model markets as efficient, always in equilibrium and self correcting where security prices simply react to random news releases. The EMH models day-to-day security price movements as “independent random variables” where purchase or sale is a “zero net present value transaction,” resulting in neither the buyer nor seller having an advantage. Consequently, security trading is modeled like casino gambling where price volatility determines risk assessment. The EMH concludes that because prices always fairly reflect intrinsic value and it is impossible to know what markets are going to do, consequently, fundamental analysis isn’t cost effective. The EMH model is both naïve and specious, i.e., it relies on incorrect premises and, therefore, cannot correctly model market risk. A discussion follows.

Markets are not always in equilibrium nor self correcting but rather are a discounting mechanism, i.e., professional traders look ahead and bid prices either up or down prior to earnings and/or economic news announcements; that is why prices can go up on bad news and down on good news. Security prices from day-to-day seem random, however, portfolio diversification cancels out unsystematic risk, therefore, markets as a whole only have systematic risk. Using a diversified market portfolio, monthly rather than daily data, trend lines and conditional probabilities based on fundamental analysis correctly models systemic market risk; thereby disqualifying the flawed EMH’s reliance on securities’ price frequency and the use of price volatility as a proxy for portfolio risk which is not sufficient information when hedging positions.

(Eric L. Prentis is the author of “The Astute Investor” and “The Astute Speculator,” http://www.theastuteinvestor.net )

]]> By: Lester N http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2737 Lester N Sun, 18 Jan 2009 18:14:50 +0000 http://baselinescenario.com/?p=1833#comment-2737 Guys: Another great blog. I really enjoy when you break down some of these fundamental concepts and explain it in ways that your audience can understand. Articles of this quality which stimulate really good feedback from the rest of us. Thank you for stimulating our minds! Guys:

Another great blog. I really enjoy when you break down some of these fundamental concepts and explain it in ways that your audience can understand.

Articles of this quality which stimulate really good feedback from the rest of us. Thank you for stimulating our minds!

]]> By: Tom C http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2563 Tom C Sat, 10 Jan 2009 21:04:20 +0000 http://baselinescenario.com/?p=1833#comment-2563 Having begun trying to understand stock investing in 1968 and learning over the years how to buy high and sell low, the market has proven to me it is irrational. At the same time, it is the only game around. In my work life as a regional planner, by the late 1980's I came to view all life ask risk management. Nassim Taleb's books provided an important perspective which led me to be more conservative recently. I made a few small bets, which may pay off. In the 35 years of my career, those that took a business administration rather than a public administration track have spent, it seems, the majority of their time trying to make money with money. They followed the OPM dictum - you get wealth by using Other Peoples' Money. I, on the other hand had to create value using OPP - Other Peoples' People - e.g. networking among and between communities. In planning for the long term I had to use economic and demographic data, as well as pay attention to markets and the impact of changing technology and globalization. These discussions about formulas and theory consume brain cells, but the net effect of all that work was that it was an illusion. Quantification is ideal for the theoretical world. We will always be beginners at risk management, no matter how much experience we have. Numbers do numb. There's always tomorrow to pay off the credit debt, providing the music does not end. As much as we may enjoy Ravel's Bolero, it does end. I wish you all well trying to be risk managers. The meteor with our name on it could be flying though space at this moment, or we may step off the curb at the wrong moment. There are losses in life, just as there are gains. To gain some objectivity within our environment is a challenge, but perhaps the only defense. A fish may only recognize water once taken out of it. Experiencing other simultaneous mental environments, cultures - places where the history, logic and underpinning rules are different, can add to our ability to make better decisions. Having begun trying to understand stock investing in 1968 and learning over the years how to buy high and sell low, the market has proven to me it is irrational. At the same time, it is the only game around. In my work life as a regional planner, by the late 1980’s I came to view all life ask risk management. Nassim Taleb’s books provided an important perspective which led me to be more conservative recently. I made a few small bets, which may pay off. In the 35 years of my career, those that took a business administration rather than a public administration track have spent, it seems, the majority of their time trying to make money with money. They followed the OPM dictum – you get wealth by using Other Peoples’ Money. I, on the other hand had to create value using OPP – Other Peoples’ People – e.g. networking among and between communities. In planning for the long term I had to use economic and demographic data, as well as pay attention to markets and the impact of changing technology and globalization. These discussions about formulas and theory consume brain cells, but the net effect of all that work was that it was an illusion. Quantification is ideal for the theoretical world. We will always be beginners at risk management, no matter how much experience we have. Numbers do numb. There’s always tomorrow to pay off the credit debt, providing the music does not end. As much as we may enjoy Ravel’s Bolero, it does end. I wish you all well trying to be risk managers. The meteor with our name on it could be flying though space at this moment, or we may step off the curb at the wrong moment. There are losses in life, just as there are gains. To gain some objectivity within our environment is a challenge, but perhaps the only defense. A fish may only recognize water once taken out of it. Experiencing other simultaneous mental environments, cultures – places where the history, logic and underpinning rules are different, can add to our ability to make better decisions.

]]> By: War on VAR « Mostly Economics http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2442 War on VAR « Mostly Economics Tue, 06 Jan 2009 07:32:34 +0000 http://baselinescenario.com/?p=1833#comment-2442 [...] by Yves Smith of Naked  Capitalism Blog calling it misleading. James Kwak of Baseline Scenario neatly sums upNocera and Smith [...] [...] by Yves Smith of Naked  Capitalism Blog calling it misleading. James Kwak of Baseline Scenario neatly sums upNocera and Smith [...]

]]> By: Top Posts « WordPress.com http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2436 Top Posts « WordPress.com Tue, 06 Jan 2009 00:33:56 +0000 http://baselinescenario.com/?p=1833#comment-2436 [...] Risk Management for Beginners For a complete list of Beginners articles, see the Financial Crisis for Beginners page. Joe Nocera has an article in [...] [...] [...] Risk Management for Beginners For a complete list of Beginners articles, see the Financial Crisis for Beginners page. Joe Nocera has an article in [...] [...]

]]> By: David Harper http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2430 David Harper Mon, 05 Jan 2009 20:33:09 +0000 http://baselinescenario.com/?p=1833#comment-2430 Just to clarify common misconceptions about VaR: * VaR models do not typically assume normality except maybe for short-term (daily) market risk. Not credit risk, not oprisk * VaR is typically not approached as above. It is typically one of: historical, monte carlo, or parametric. Or some hybrid of the two. * Historical and monte carlo do not require a distributional assumption * The point of the article, time varying distributions, is a really great point. So, we maybe can't solve it. However, there are VaR models that can at least try to model conditional VaR or VaR based on conditional (time-varying volatility). So, again, the VaR framework is quite simple and allows for addressing many of this perceived shortcomings. David Harper Just to clarify common misconceptions about VaR:

* VaR models do not typically assume normality except maybe for short-term (daily) market risk. Not credit risk, not oprisk

* VaR is typically not approached as above. It is typically one of: historical, monte carlo, or parametric. Or some hybrid of the two.

* Historical and monte carlo do not require a distributional assumption

* The point of the article, time varying distributions, is a really great point. So, we maybe can’t solve it. However, there are VaR models that can at least try to model conditional VaR or VaR based on conditional (time-varying volatility). So, again, the VaR framework is quite simple and allows for addressing many of this perceived shortcomings.

David Harper

]]> By: Mark A. Sadowski http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2427 Mark A. Sadowski Mon, 05 Jan 2009 16:20:38 +0000 http://baselinescenario.com/?p=1833#comment-2427 My favorite appraisal of Value at Risk comes from David Einhorn (President of Greenlight Capital, a hedgefund). He said that VaR "is like an airbag that works all the time, except when you have a car accident." The quote can be found in its context here: http://www.garpdigitallibrary.org/download/GRR/2012.pdf As Mr. Kwak points out, VaR has a number of mathematical inadequacies but its principle problem is its inability to to tell you what happens the other 1% of the time (the tails). But the fact that it was easy to use caused it to be excessively relied on by senior executives and regulators, and it ultimately led (ironically) to excessive risk taking. Mathematical tools are nice, even inadequate ones, but one shouldn't get excessively dependent on any one thing when trying to make forecasts or predictions. Asset bubbles always seem to be a product of a psychological positive feedback loop that leads to a herd mentality. There was plenty of evidence from the past that both the dotcom bubble and the housing bubble were going to bust eventually. But in both cases the herd mentality had caused otherwise rational people to conclude that this time was somehow different, that we were living in a new era where things always go up and never come down. Sometimes a little common sense trumps a somewhat sophisticated but highly flawed mathematical tool. My favorite appraisal of Value at Risk comes from David Einhorn (President of Greenlight Capital, a hedgefund). He said that VaR “is like an airbag that works all the time, except when you have a car accident.” The quote can be found in its context here:

http://www.garpdigitallibrary.org/download/GRR/2012.pdf

As Mr. Kwak points out, VaR has a number of mathematical inadequacies but its principle problem is its inability to to tell you what happens the other 1% of the time (the tails). But the fact that it was easy to use caused it to be excessively relied on by senior executives and regulators, and it ultimately led (ironically) to excessive risk taking.

Mathematical tools are nice, even inadequate ones, but one shouldn’t get excessively dependent on any one thing when trying to make forecasts or predictions. Asset bubbles always seem to be a product of a psychological positive feedback loop that leads to a herd mentality. There was plenty of evidence from the past that both the dotcom bubble and the housing bubble were going to bust eventually. But in both cases the herd mentality had caused otherwise rational people to conclude that this time was somehow different, that we were living in a new era where things always go up and never come down. Sometimes a little common sense trumps a somewhat sophisticated but highly flawed mathematical tool.

]]> By: Edgar http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2426 Edgar Mon, 05 Jan 2009 16:04:18 +0000 http://baselinescenario.com/?p=1833#comment-2426 I believe it is time to incorporate more qualitative research into finance rather than merely quantitative research. The combination of the two could handle better the events that seems unlikely to happen. For example an investor could change the distribution of his/her portfolio depending on the season of the year, an expected change in politics, or so. I believe it is time to incorporate more qualitative research into finance rather than merely quantitative research. The combination of the two could handle better the events that seems unlikely to happen. For example an investor could change the distribution of his/her portfolio depending on the season of the year, an expected change in politics, or so.

]]> By: Goose http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2424 Goose Mon, 05 Jan 2009 11:50:13 +0000 http://baselinescenario.com/?p=1833#comment-2424 @ Independent Accountant - "Coin toss is not risk, only uncertainty" - so what is risk if not for uncertainty? Suppose you had bet a million dollars on the outcome of a coin toss? Is that not risk? Your second statement - "Risk is change" is also not devoid of pitfalls. The correct statement would be -risk is that change which affects you in a negative sense. @ Independent Accountant – “Coin toss is not risk, only uncertainty” – so what is risk if not for uncertainty? Suppose you had bet a million dollars on the outcome of a coin toss? Is that not risk?
Your second statement – “Risk is change” is also not devoid of pitfalls. The correct statement would be -risk is that change which affects you in a negative sense.

]]> By: links for 2009-01-04 at DeStructUred Blog http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2417 links for 2009-01-04 at DeStructUred Blog Mon, 05 Jan 2009 02:06:18 +0000 http://baselinescenario.com/?p=1833#comment-2417 [...] Risk Management for Beginners (tags: risk finance crisis blog) [...] [...] Risk Management for Beginners (tags: risk finance crisis blog) [...]

]]> By: Independent Accountant http://baselinescenario.com/2009/01/04/risk-management-var/#comment-2413 Independent Accountant Sun, 04 Jan 2009 23:51:02 +0000 http://baselinescenario.com/?p=1833#comment-2413 VAR is scientism. Financial engineers want the public to think they are a bunch of Einsteins. What nonsense. Stock price changes are not like trying to measure Planck's constant. Economists try to impress people by attempting to quantify that which is inherently unstable. Stock market returns are not like coin flips. Coin flips of a "fair coin" have no risk, just "uncertainty". Risk is change. VAR is scientism. Financial engineers want the public to think they are a bunch of Einsteins. What nonsense. Stock price changes are not like trying to measure Planck’s constant. Economists try to impress people by attempting to quantify that which is inherently unstable. Stock market returns are not like coin flips. Coin flips of a “fair coin” have no risk, just “uncertainty”. Risk is change.

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