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Risk Management: In the Eye of the Storm

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After VaR: Q&A with Ron Papanek

What Will Measure Risk Better?

December 15, 2010
By Tom Steinert-Threlkeld

Value at Risk, aka VaR, is a measure of how much value a portfolio of financial assets is at risk of losing in one day, watched closely by nearly all Wall Street firms in their daily operations.

But it is generally calculated as the amount that can be lost in one trading day out of 20.

The model came out scathed by the worldwide credit crisis, since it did not keep banks or other financial firms from experiencing bigger losses than projected by the benchmark.

Here’s the nub: Value at Risk judges the potential loss in a given period with either 95 percent or 99 percent confidence. By its nature, it does not forecast what the loss might be in an extreme case where a one percent or five percent probability event comes into play.

The result: The “value at risk” model is not set up to protect against a perfect storm of events, such as occurred in 2008. If banks have had lax lending practices, mortgagees have loans they can only afford if they keep refinancing and then housing prices fall … this measurement won’t capture the confluence or calculate a loss based on it.

The measure grew out of a request in 1989 by the chairman of J.P. Morgan for a daily report on the risks facing the investment bank.

In 1998, J.P. Morgan spun off its risk management expertise into a for-profit firm called RiskMetrics Group.

RiskMetrics this year was acquired by MSCI, the global marketer of indices, once known as Morgan Stanley Capital International.

Ron Papanek, who headed RiskMetrics Group’s RiskMetrics Labs unit, spent a decade at J.P. Morgan Securities. He is now head of MSCI’s Alternative Investments Business, focusing on hedge fund risk management.

STM: I guess the criticism that came up over the last two years with Value at Risk as a management tool is related to extreme volatility, which it doesn’t capture.

RP: VaR is a useful tool, it’s a useful framework for looking at risk, but it is not the only framework and it is not the end-all. And if you assume that it will solve all your problems, you will fail.

STM: So what comes next?

RP: There are other tools that are also very valuable and, naturally, should be used alongside of VaR. And many asset managers spend much more of their time focusing on these other tools. These come in three particular areas: stress testing, counterparty risk and liquidity risk.

STM: Take them, in order.

RP: Stress testing itself is probably the main tool that traders and investors use alongside of Value-at-Risk.

STM: And this, of course, is where you run portfolios against different economic and political scenarios to see what the effect might be.

RP: At one level stress testing is just about sensitivity analysis, so just looking at your risk relative to specific shocks in the marketplace. In other words, what happens if equities drop 10 percent? What happens if interest rates rise 50 basis points?

STM: How do you stress test for stuff you haven’t seen before, like 2008?

RP: The two areas I think that have gained a lot of focus recently are conditional stress testing and reverse stress testing.

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