Sunday, March 20, 2011

limitations of risk models - Haitao discussion

[haitao] Your view on risk management matches with one of our professor's, he also believes that using risk models such as VaR does not suffice the purpose of risk management, it is really a very broad field that needs to be explored further. This is actually at frontier of academic research, in particular, Professor mentioned 3 flaws associated with VaR: 1. Not considering the magnitude of loss beyond VaR. 2. VaR penalizes firm diversification. 3. Fat-tail issues related assuming distribution of critical events failed to reflect market situations. I have also attached his research paper drafted in 2010, he is very well known in Fix Income field.

[Bin] I feel VaR is the best concept I know today (except Expected Shortfall) but very, very imperfect. As I said earlier,

I feel any attempt to predict how market reacts to extreme events is futile as such extreme events are rare and we have limited experience with them. -- Black Swan theory

How do you predict the impact of a comet hitting the earth, if you have not analyzed 100 similar collisions?

When liquidity dried up in 2008, I was told every bank held on to whatever cash it had and refused to lend. All our models fail. US government had to create about 1000 billion new dollars. No one can predict this either.

Similarly, some governments (Germany after WWI??) prints so much money that a cow's price shot up not 100% but 100,000,000% in a year. No risk system can handle such inflation. I remember photos of German children playing with bundles of bank notes as toy bricks.

More recently, Iceland, Greek and Irish governments went bankcrupt. I doubt any VaR system accounts for such extreme possibilities.

What kind of risk system predicted the impact of Freddie and Fannie failures (or Lehman, Bears and AIG)? I doubt. I feel even the strongest (like Goldman Sachs) would not survive if AIG goes bankrupt without government bailout, since AIG is insurance for GS.

You can have lots of smart hedges to protect big risky positions but what if the instrument used in the hedge itself becomes illiquid and worthless, or the counterparty is unable to fulfill its obligation? Can risk models predict that half of all market participants go bankrupt together?

Many derivative markets are subject to tighter regulation. Perhaps liquidity and spread will worsen?? VaR systems must adjust for such policy changes and predict the implications? Hopeless in my opinion.

Sometimes I feel the risk analysts are ostriches burying their heads. They know a lot of extreme market events are not accounted for in their system but they just wish them away (just to keep their jobs and keep their research projects alive). They see the emperor's new dress is naked but don't dare to say.

[haitao] I recall some of the interview questions from BB in Hong Kong and Singapore:

a. All sort of behavioral questions: Tell me a time...Why us...Why this position...Leadership...

Problem solving...Resolve Conflicts...etc
b. What do you think tax cuts extension impact on yield curve?
c. What is your view on Asian markets particularly Chinese stock market in 2011?
d. Why do you think Commodity price should surge even higher? What are the factors cause such dynamics?
e. For historical US and Japanese interest rates, one of them is normally distributed and the other is log-normally distributed, which is which? Justify your answers?
f. Explain Fix Income to a layman.
g. Discussion on recent market events.

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