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  • Writer's pictureWilliam Webster

Follow the money

The earlier reported loss of $2bn at JP Morgan has reignited the debate “What use VAR?” VAR you will recall is a statistical technique that tells banks how much they can lose for a given holding period for a given confidence interval. The confidence interval however never reaches 100%. Sometimes the loss is so much greater than the VAR that the whole methodology is brought into disrepute simply because financial markets don’t behave “normally”. Over a decade ago I asked traders what they thought of VAR and the results were uniform. They totally mistrusted it. Why?

  1. VAR was a “black box” where cause and effect were difficult to see;

  2. Deltas and a “feel” for the market could tell you when positions were large;

  3. Out of the money options traded with a “smile” because outlying events did happen;

  4. Basis risks were real and correlations weren’t stable. Despite these criticisms one number telling you all you need to know without getting too close to markets was an improvement. But like all tools VAR is merely a colour in a paint box. It adds to the picture. But would you paint in monochrome? Strangely enough it seems that is exactly what we did.  So what about stress testing? It’s not new but bringing it in as the central measure is. Is stress testing all it’s cracked up to be? Are we making the same mistake all over again? If I’d asked that question a decade ago the traders would have said.

  5. We tried it and our limits were far too large;

  6. We are still under pressure to deliver;

  7. Profitable hedging must be the answer. The real danger is that whilst some risks are being reduced bankers will find new (and old) ways to make money. This will involve taking risk. It drives the business. It may be a shock but just like VAR, stress testing largely ignores these risks. What does stress testing tell you? It just shows you that the risks you think you have are greater than you thought. This should be a warning. Stress testing just like VAR is flawed. Particularly when used as a panacea- it creates a false sense of wellbeing. More weight needs to be given to where the money comes from. Something traders know.

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