Thursday, January 15, 2009
Yves Smith on VAR
Yves Smith (YS) has a 4 January 2009 post at her Naked Capitalism about Joe Nocera's (JN) NYT value at risk (VAR) model article with a link to the underlying article, link: http://www.nakedcapitalism.com/2009/01/woefully-misleading-piece-on-value-at.html. YS's post stands well. I am less favorably disposed to VAR than YS. I see VAR as scientism. Economists try convincing the public they are scientists, when that is untrue. They use mathematics to impress people as if they are nuclear physicists, or mechanical engineers or some such. No one who got an MBA from any of our quantitatively oriented MBA schools: Chicago, Wharton, MIT, Stanford, etc., in the last 35 years should have been taken in by VAR. VAR is technical stock market analysis (TSMA) in drag! If the efficient markets hypothesis did nothing else, it should have convinced people TSMA doesn't pay. Why should applying TSMA techniques to other markets work? Some excerpts from JN article YS left out, "At the very least, the risks that VaR measured did not include the biggest risk of all" the possibility of a financial meltdown". VAR does not measure "risk" at all. It assumes if the world continues as is, the likelihood of returns over a period of time is knowable. It isn't, that's why there is risk! "David Einhorn, who founded Greenlight Capital, a prominent hedge fund, wrote not long ago that VaR was 'relatively useless as a risk-management tool and potentially catastrophic when it creates a false sense of security among senior managers and watchdogs. This is like an airbag that works all the time, except when you have a car accident'." VAR justified financial institutions taking more risks. If traders knew they would be financially ruined if their positions blew up, they would take different positions. "Taleb says that Wall Street risk models, no matter how mathematically sophisticated, are bogus". I agree with Taleb. JN asked Taleb, "If he knew the people at RiskMetrics, a successful risk-management consulting firm that spun out of the original JPMorgan quant effort in the mid-1990s. 'They're intellectual charlatans, he replied dismissively, 'You can quote me on that'." Taleb sees these people more favorably than I. Taleb must believe they believe what they are saying, i.e., they are fools as opposed to knaves. Taleb may be right. "'VaR is not just one invention,' [Till Guldiman, JPMorgan banker] said. 'You solved one problem and another cropped up. At first is seemed unmanageable. But as we refined it, the methodologies got better'." Shades of epicycles. "Aaron Brown ... the risk manager at AQR said, In peacetime, you think about other people's intentionas. In wartime, only their capabilities matter. VaR is a peacetime statistic'." Fool, only consider capabilities. Anyone who knows military history could tell you "intentions" are masked or as Sun Tzu and the Prophet (PBUH) told us, "Deception is the essence of warfare". "Guldiman, the great VaR proselytizer, sounded almost mornful when he talked about what he saw as another of VaR's shortcomings. To him, the big problem was that it turned out VaR could be gamed". Had Guldiman asked me, I could have told him this. "Taleb says that because VaR didn't measure the 1 percent, it was worse than useless--it was downright harmful. But most of the risk experts said there was a great deal to be said for being able to manage risk 99 percent of the time, however, imperfectly, even though it meant you couldn't account for the last 1 percent". These "risk experts" are fools. They are accountants, historical cost accountants! They aren't "managing" anything. They are just playing accounting games using historical data.
Jan Danielson (JD), a London School of Economics, attacks risk measurement on 5 January 2009, here: http://voxeu.org/index.php?q=node/2753. Way to go JD!