Bellouard: The future of VaR

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17 October 2011

How has the financial crisis changed our attitudes to value at risk?

For many risk managers, the unrelenting financial meltdown has left them questioning the very essence of risk modelling. While investment firms have traditionally relied on fantastically complex mathematical models for measuring the associated risk in their various portfolios, the events of the past three years has left the reputation of risk modelling in tatters. With this in mind risk management, and in particular Value at Risk (VaR), now needs to evolve to enable more accurate calculations and foresight.

In short VaR allows banks and investment firms to make quick and simple predictions on the potential losses of trading. While its use is undeniably invaluable, its ability to estimate tail risk has been criticised following the worldwide financial crisis. Although its application has been extended in many ways to reflect liquidity risk and take into account operational risk and basic stop losses, it is still backward looking and can fall short if there is an extreme change in price.

While many argue that the current VaR model needs to be addressed, one could argue that it is more banks’ and traders’ approach to, and use of VaR, that needs to change, rather than the actual model itself. The question is how?

Firstly, VaR needs to be broken down and analysed by traders. Instead of relying on a single number, traders need to look beyond the top line and delve into the complex mathematical calculations to gain a better understanding of the type of risk they are taking and how it can best be mitigated. By taking this approach VaR will become a valuable management tool, alongside other factors, such as the Profit and Loss sheet.

Secondly, as well as better analysis, traders need to receive VaR calculations in a timely manner. When used simply as a reporting tool, receiving VaR calculations within 24 or 48 hours is adequate. However, if traders are to have the ability to act on the information provided within the VaR calculation, they require the information within the trading day. A firm’s ability to understand its risk position in near real-time can allow it to undertake more and / or greater positions and trade across complex products with more confidence.

As we know many of these considerations are currently being mandated by the regulators.

However, it is expected that the emerging regulations will not only require a change of culture but also a review of banking systems. As it stands, many financial institutions simply do not have the right technology in place to deliver in-depth VaR analysis in a timely fashion and will need to embrace new technology and implement more sophisticated risk mitigation solutions and approaches.

At the end of the day, the widespread institutional reliance on models such as VaR, as an accurate indicator of market risk, is only a gamble if traders do not have the right technology solutions in place to help them analyse and break down VaR in near real-time.

Xavier Bellouard is a co-founder of Quartet FS

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