Sunday, January 4, 2009

The Risky Business of “Value at Risk”

In today’s New York Times Magazine, Joe Nocera’s Risk Mismanagement tells the story of a metric, Value at Risk (VaR), that was central to 2008’s financial woes.

VaR is a single number that “measures the boundaries of risk in a portfolio over short durations, assuming a ‘normal’ market. For instance, if you have $50 million of weekly VaR, that means that over the course of the next week, there is a 99 percent chance that your portfolio won’t lose more than $50 million.”

Much of the article is about the financial establishment’s willingness—in some respects, eagerness—to embrace VaR’s simple rendering of risk while ignoring the one-percent-chance scenarios VaR did not quantify. Although firms had risk experts that understood this blind spot, Nocera concludes the experts lacked either the will or the clout to stop everyone else from misunderstanding it:

There were the investors who saw the VaR numbers in the annual reports but didn’t pay them the least bit of attention. There were the regulators who slept soundly in the knowledge that, thanks to VaR, they had the whole risk thing under control. There were the boards who heard a VaR number once or twice a year and thought it sounded good. There were chief executives like O’Neal and Prince. There was everyone, really, who, over time, forgot that the VaR number was only meant to describe what happened 99 percent of the time. That $50 million wasn’t just the most you could lose 99 percent of the time. It was the least you could lose 1 percent of the time. In the bubble, with easy profits being made and risk having been transformed into mathematical conceit, the real meaning of risk had been forgotten. Instead of scrutinizing VaR for signs of impending trouble, they took comfort in a number and doubled down, putting more money at risk in the expectation of bigger gains. “It has to do with the human condition,” said one former risk manager. “People like to have one number they can believe in.”

The full article is worthwhile reading.

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