Risk

03/28/2011

Just One Question: 
Did You Calculate the Risk?

The movie Stalag 17 opens with an escape attempt from an Austrian POW camp during World War II. Two POWs, Manfredi and Johnson, are preparing to escape through a tunnel that has been secretly constructed beneath one of the camp’s latrines. As the two would-be escapees go through a last minute review of their plans with Hoffy, the barrack chief, and Price, the barrack security officer, a skeptical POW asks a key question.

Continue reading "Just One Question: 
Did You Calculate the Risk?" »

02/01/2011

The Seat Belt Problem: A New Approach to Calculating Risk-Adjusted Returns

“People don’t perceive that they are going to be the one in a crash,” laments Russ Rader, media director at the IIHS (Insurance Institute for Highway Safety). “They believe that they are in control when they’re behind the wheel. They don’t sense how high the risk actually is.” The IIHS, a Virginia-based, national nonprofit that has helped significantly increase seat belt usage in the last twenty years, has a simple objective: lessen the risk taken in everyday driving behavior. The risk-measurement approach it employs has the potential to revolutionize how the investment community evaluates manager performance.

In our industry any credible performance comparison is risk adjusted. It makes no sense to equate the returns of two funds that take different amounts of risk. The challenge has always been how to measure the risk taken by managers—mathematically speaking, what to stick in the denominator.

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11/01/2010

Proceed with Caution: The Pitfalls of Value at Risk

Value at Risk, or VaR, continues to garner a great deal of attention from the investment community, the media, and academia. While it is commonly used at banks, in trading depart-ments, and by many asset managers, we must ask how reliable it is. In Lecturing Birds on Flying (2009), Pablo Triana criticizes it amply; however, there may be more objective ways to grasp its shortcomings.

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10/07/2010

In Defense of a Quant (Part II): The Ups and Downs of the Normal Distribution

In my previous column, I mentioned that particular attacks on the deficiency of mathematical finance are centered on the alleged misuse of “simplistic” normal distribution by the quants. Nassim Taleb never fails to contrast the disdainful and primitive “Brownian” paradigm with the supposedly more sophisticated “fractal” point of view, which he attributes to Benoît Mandelbrot. I quote only two passages from the Black Swan: “I find it ludicrous to present the uncertainty principle as having anything to do with uncertainty. Why? First, this uncertainty is Gaussian.” Or another pick: “So selecting the Gaussian while invoking some general law appears to be convenient. The Gaussian is used as a default distribution for that very reason.”

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08/19/2010

Commentary: From Risk to Uncertainty

Stress-test complacency will be a cause of the next financial meltdown.

Economic commentators have been increasingly using the word “uncertainty” as of late. The context has included the business climate, the stimulate vs. austerity debate, and forecasting the investment outlook across capital markets. 

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07/21/2010

The Greater Fool Theory: Managing and Modeling Risk

The most dramatic financial meltdown since the Great Depression occurred despite recent advances in risk management techniques. Because of a fervent but unfounded belief in some quarters that VaR (value at risk) measures worst-case scenarios, financial institutions were exposed to crippling losses when VaR models failed to anticipate the extent of potential price movements, in some cases by whole orders of magnitude. 

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06/08/2010

Crisis Mode: Modern Portfolio Theory Under Pressure

Illustration by Mark Andresen

During financial crises correlations among security returns approach one.

Therefore, diversification fails just when you need it.

Therefore, MPT (modern portfolio theory) is of no use.

The first of the statements above is correct; the second is partially true; the last statement is false. In order to understand the assertions of the last sentence, we need to review what MPT is and is not, what it offers and what it does not promise.

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05/14/2010

The Hierarchy of Risk: A New Approach to Risk Management

Risk culture is comprised of those values and behaviors, on the parts of both management and employees, which define an organization’s awareness of and approach to risk. As the financial crisis continues, the most successful firms have been those possessing risk cultures with high awareness, quick escalation, and strategic flexibility. There are echoes of behavioral finance in the way an organization’s view of risk may be skewed by its current investment appetite, its compensation and incentives, and its degree of knowledge of historical risk. Complicating this risk culture is quantitative modeling of limited historical data, decreasing transparency due to financial product innovation, and overreliance on credit ratings.

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05/04/2010

A Primer on Value at Risk

Value at risk, or VaR, is viewed by some as a massively important measure. It is unique in how it characterizes risk. Most measures show risk either as a percentage (as standard deviation and tracking error do) or in units (as the Sharpe and Treynor risk-adjusted measures do). VaR shows risk in terms of money—that is, the money that might be lost.

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04/22/2010

Calculating the Risks of Impending Water Shortages

World Water UsageWater is taking center stage alongside the emission of carbon as the preeminent environmental risk facing the planet in the twenty-first century. And, in a manner similar to its early response to carbon risk, the private sector has begun to prepare for an era of stricter regulation and rationing of what is perhaps the earth’s most precious finite resource.

The media has recently focused on water scarcity primarily from a climate-change perspective. Glacial melting—which Achim Steiner, executive director of the UNEP (United Nations Environment Programme), has called “the canary in the coal mine”—is reportedly depleting the freshwater supply of vast regions of Asia and South America. 

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