My Car is a Fraud

by Rick Nason PhD, CFA

Partner RSD Solutions Inc

www.rsdsolutions.com

info@rsdsolutions.com

 

There has been a whole lot of writing lately about how Value at Risk (VAR) is a fraud as a risk measure. Not quite sure what all of these writers are complaining about so I thought I would try out some of their reasoning. To do so I tried to make a latte with my car. You know what – the people who claim that VAR is a fraud are right – I could not make a latte with my car – although it is what I consider to be quite a nice car.

After reading that paragraph you are probably thinking that I have gone loco. Of course I cannot make a latte with my car. My car (any car) is for driving, not for making lattes. Even a child knows that. However those who argue that VAR is a fraud because it did not allow financial institutions to see the crisis coming are missing the point – just as I am missing the point thinking that my car could make a latte.

VAR and other risk measures and tools are actually quite good at what they are designed for. VAR however is not a prediction tool for a crisis, and VAR is not a great tool for assessing systematic risk.

All too often in risk – as in other fields – we have a temptation to use whatever tools we have for whatever purpose. It is just like the old saying that “to the inexperienced builder holding a hammer that everything looks like a nail.” Just because you have a specific tool or metric that some smart people developed, does not mean it is appropriate in all cases and for all situations. That is simply common sense.

Meanwhile I have to go get into my car so I can go get a latte at Starbuckys.

VAR Trend is Your Friend (or at least a good early indicator)

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.rsdsolutions.com

info@rsdsolutions.com 

 

For some reasons a lot of stuff has come across my desk recently that is bashing Value at Risk (VAR) and saying that it is a symbol for all that is bad in risk modeling.  I think it is time for a time-out.  As risk specialists, we also have to be optimists and look for the good in everything. 

One thing that I think that VAR is good at is indicating change.  I too recognize the limitations of VAR.  (One of the reasons so much is crossing my desk is that I teach several different courses in financial risk and also in Enterprise Risk Management.)  The limitations have been well documented. 

What is less well recognized is that VAR is still a very useful tool.  One of the ways to use VAR that helps to maximize its usefulness while minimize its weaknesses is to follow the trend of how the company (or project) VAR is tracking.  Looking at the trend, rather than the absolute number, can help you to ascertain when a shift in risk exposure has occurred.  It will also help to base-line out the traditional faults such as the use of parametric statistics or the use of the incorrect distribution. 

Tracking the trend of VAR is not a perfect remedy.  Watching the trend of a bad and inaccurate model, will still give useless and potentially misleading results.  However if a decent VAR model is constructed, and if more attention is paid to the trend than the absolute VAR number, then more useful (and accurate) information will be generated.