Escolar Documentos
Profissional Documentos
Cultura Documentos
Daniel Satchkov
is the President of RiXtrema Inc., a risk modelling and consulting firm that focuses on the extreme financial
market events. Prior to founding RiXtrema, he was an Associate Director of Risk Research at FactSet, where he
was responsible for researching and developing software products in the areas of risk measurement and risk
reporting. He has spoken at numerous conferences and published articles dealing with risk management
issues in such magazines as Journal of Asset Management, Investment and Pensions Europe, as well as in a
number of white papers and an e-book. Daniel’s current research is in the area of extreme market events,
credit cycles and behavioural finance. Daniel holds BS and MBA degrees from the University of the Pacific.
Abstract The market events of 2008 will be remembered as much for their
extreme volatility as for a widespread failure of the risk management, which
contributed to the near collapse of many firms thought to be among the leaders
in that field. This paper identifies a key deficiency in the way that the historical
data are currently utilised in the estimation of risk. This deficiency stems from
the conception of the marketplace as an equilibrium-seeking and continuous
system and it led to the financial firms’ unpreparedness for sudden market
reversals. A different framework for risk estimation is proposed based on linking
the risk modelling with the existing literature on financial instability. One
possible application of the proposed method to the estimation of value-at-risk
(VaR) is demonstrated, and empirical tests comparing it with the traditional
methods are performed using S&P 500’s history from 1989 to 2010. The new
measure, called the instability VaR, is shown to dominate all traditional
methods of calculation.
366 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)
When swans are grey: VaR as an early warning signal
boom-bust patterns and their relation to historical VaR are all different measures
pricing of risk. While the paper will of the risk metric called VaR.
focus on VaR, the ideas presented here VaR has a statistical definition (it is a
are general and can be applied to the quantile of a distribution), and nothing
estimation of any risk statistic. in this definition implies that it has to be
based on a bell curve calibrated
exclusively on recent returns as is the
PROBLEMS WITH CURRENT case with most accepted models today. In
VAR IMPLEMENTATION other words, there are different ways of
VaR is the most commonly used metric measuring the metric called VaR.
of market risk. However, VaR is Extreme value theory methods do not
frequently the subject of criticism, and assume any particular overall distribution
this paper will consider some of the and Monte Carlo simulation VaR can be
arguments against it that carry the most based on many distributions, including
validity. various power law distributions that
The most often voiced objection to Taleb favours.1 These distributions can
VaR stems from the obvious model the effects of the ‘fat tail’, which
inappropriateness of the normal frequently and painfully asserts itself in
distribution for the modelling of the financial markets, although, as will be
medium- to short-term financial returns. seen, there are practical problems with
The fact that the short-term returns are those versions of VaR as well. Lack of
not distributed according to a bell curve awareness of the basic distinction
can be hardly disputed at this point. It is between the measure and the metric
enough to consider the simple fact that sometimes leads to definitions of VaR
daily returns of the S&P 500 display a which state that it is only valid during
kurtosis of greater than 7 over the three ‘normal conditions’. It is astonishing that
years even prior to August 2008. A anyone would even consider using a risk
popular version of this argument against measure that only functions when one
VaR can be found in Nassim Taleb’s does not need it. The goal in this study
Black Swan: The Impact of the Highly is not to discard VaR, but rather to make
Improbable.1 However reasonable it sure it better accounts for the drastic
appears, this argument should not be market reversals that seem to always catch
levelled at VaR as a metric of risk, but quantitative risk systems by surprise.
rather at one particular way of calculating
VaR, namely the parametric or normal THE REAL PROBLEM: EQUAL
distribution VaR based on a particular WEIGHTED AND DECAY TIME
way of incorporating historical data. WEIGHTED ESTIMATORS
This misunderstanding is based on a The main problem that makes the
confusion of the concepts of measure current risk measurement dangerously
and that of the metric. Measure is an inadequate lies not in a distributional
operation for assigning a number to assumption, but rather in the way that
something; there could be many ways of the historical data is incorporated in the
doing so. Metric is the interpretation; for risk estimates. The current methods for
example, VaR is a metric, see Holton.2 using past observations gradually became
Parametric VaR, Monte Carlo VaR and axioms that are completely divorced from
# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 367
Satchkov
the market realities or any new economic estimate leaves the risk analyst completely
thinking. Currently, there are two unaware of what extreme conditions
common methods for incorporating the could do to their portfolio. The
past observations into the estimates of historical data gathered during the period
risk metrics. This paper will call them of moderate or low volatility that
the equal weighted (EW) and decay time persisted just before the crisis will
weighted (DTW). The equal weighted severely understate the risk potential in
estimator of (co)variance (for a normal the market. Problem 2: In addition, the
distribution, which is being used here, equal-weighted estimator adjusts very
the risk and variance are assumed to be slowly to changes in the market
synonymous) is derived directly from conditions and may indicate low risk
statistics where an unbiased estimator of long after it is obvious to even the most
(co)variance is equal to: casual observer that the high-volatility
period has commenced.
1 X
n
EW 2
s j;k ¼ ½r j;i rk;i ð1Þ The DTW estimator is an attempt to
n 1 i¼1 correct the second of these problems by
making the estimate more sensitive to the
where: recent market conditions. The DTW
r j;i — return of asset j or k at time i (co)variance estimate could be written as:
n — number of observations. TDW
The VaR is then calculated as: s2j;k
2 3
VaR ¼ ks j;k ð2Þ Xn 6 li1 r r
6 j;i k;i 77
¼ ð1 lÞ 4Pn 5
where: i¼1 ð1 lÞ l l1
k — scaling based on the confidence l¼1
level of VaR. n h
X i
1
In terms of economics the implicit ¼P
n li1 r j;i rk;i
assumption in the use of this method for ll1 i¼1
l¼1
modelling variability of the returns is that
a system is being observed that is ð3Þ
relatively stable over the time period of
observation and is projected to continue
l — exponential decay factor
l,i — indicators of time
this behaviour into the future period
covered by the risk forecast. This rj,i — return of asset j or k at time i.
assumption seems to be inspired by the It can be seen that in this calculation
economic theories which purport the the more recent periods are meant to
existence of a long-term equilibrium in carry progressively more information
the economic and financial system. and are weighted accordingly. The
Nevertheless, there are two obvious implicit economic assumption can be
practical problems with this approach for understood in relation to the EW
the purposes of the risk estimation. estimator and consists of allowing the
Problem 1: If a sudden crisis erupts market and the financial equilibrium to
after a period of moderate volatility and vary more rapidly with time. The
low or moderate correlations, the risk DTW approach does indeed solve the
368 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)
When swans are grey: VaR as an early warning signal
# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 369
Satchkov
relatively stable ‘equilibrium’ state. There unstable. The second theorem of the
are a number of economic approaches financial instability hypothesis is that over
that can be helpful in this regard. De periods of prolonged prosperity, the
Long et al. 3 show a model of market economy transits from financial relations
bubbles in which rational traders who that make for a stable system to financial
follow positive-feedback strategies are relations that make for an unstable
buying with rising prices and selling system.’5
with falling prices, thus producing
self-sustaining trends which ultimately Soros6 extensively discusses his view of
end in a crash. The situation of demand boom-bust sequences. His description,
rising with the price not infrequently although less rigorous than Minsky’s, gives
encountered in financial markets upsets a useful view into the mechanism of
traditional supply-demand relationships self-sustaining bubbles via the mechanism
and makes traditional equilibrium he calls ‘reflexivity’. Economy can deviate
approaches incapable of dealing with the very far from a theoretical equilibrium for
real world fluctuations. De Long et al.’s long periods of time, because many
model formalises a permanent theme in so-called ‘fundamentals’ under certain
the literature on self-reinforcing bubbles conditions can become highly intertwined
which goes back as far as Bagehot.4 with prices, which are supposed to reflect
Going further, Hyman Minsky5 them. The views of both Minsky and
identified the key features of the credit Soros explain how the risk gets built up to
cycle which tend to drive large an extremely high level owing to purely
boom-bust sequences. According to the endogenous market forces. The stage is
financial instability hypothesis (FIH), then set for a dramatic reversal. In an
fundamental relationships in the real exceptionally lucid explanation of systemic
economy and financial markets change risk, Danielsson and Shin7 write:
with the change in the behaviour of the
participants and particularly with the ‘One of the implications of a highly
change in the behaviour of the financial leveraged market going into reversal is that
intermediaries. For example, after a a moderate fall in asset value is highly
period of prosperity, an increase in the unlikely. Either the asset does not fall in
risk-taking activities takes place and value at all, or the value falls by a large
rising leverage builds, setting up the amount.’
potential for a violent downturn. Some
interruption will expose the Let us now summarise these insights in a
unsustainability of leverage levels leading framework that will help to develop a
to a credit contraction and a potential risk modelling approach, which can truly
collapse in the asset values. estimate risks, that is provide an early
Minsky summarised his insights in two warning of the instability potential.
theorems of the financial instability:
FRAMEWORK FOR THE
‘The first theorem of the financial INSTABILITY RISK APPROACH
instability hypothesis is that the economy (1) Financial market behaviour can be very
has financing regimes under which it is roughly divided into two states: a stable
stable and financing regimes in which it is state where a financial economy is an
370 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)
When swans are grey: VaR as an early warning signal
# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 371
Satchkov
nothing about the potential changes in are met in relation to the risk
its likelihood. This is why it is necessary (mis)pricing metrics.
to draw on the ideas outside of a purely In the interest of the simplicity of
statistical framework to estimate the presentation, one can take the most basic
instability potential of the economy. The and perhaps most widely used type of
author here argues that statistics should VaR, the parametric VaR, and start with
be strictly subordinate to the economic the EW and DTW methods of using the
reasoning in risk modelling and that past data for its estimation. One will then
heuristics should be used where they are introduce an instability estimator of
necessary. parametric VaR. The testing of the
instability estimator will show that, even
INSTABILITY ESTIMATOR OF with an obviously simplistic parametric
THE PARAMETRIC VAR VaR, it can do a good job of capturing
The conclusions in the above framework tail risks.
lead to the new paradigm for the
inclusion of the past data in the risk
estimation process. As the excess Construction of the instability
risk-taking persists, a financial economy estimator of parametric VaR
becomes increasingly vulnerable to all EW and DTW estimators of VaR have
types of shocks. This framework already been described above. This paper
motivates the following definition of a will now describe the instability estimator
new class of risk estimates: and run back tests comparing the three
of them. Since parametric VaR is being
Instability estimator of risk (IER) is used, the instability estimator of
calculated by assigning progressively (co)variance will take the following
greater weight to the observations from form:
the extreme portion of the sample when
c h i
two conditions are present: INST 1 X
s2j;k ¼ WEX r EX r EX
n t¼1 j;t k;t
372 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)
When swans are grey: VaR as an early warning signal
r EX
j;t — selected extreme period return of the concept to be tested without delving
the asset j or k at time t into the issues of the generalisation of the
and the instability estimator of parametric IER concept to the multiple asset/
VaR for asset j: multiple factor model.
With the above considerations in mind,
VaR ¼ k ðINST s j;j Þ the weighting function can be introduced:
# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 373
Satchkov
374 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)
When swans are grey: VaR as an early warning signal
DTW methods. The two exceptions author does not view these false alarms
are a few months at the end of 2004 as failures of the model; rather they
and the second half of 2005. The represent ‘tests of the bubbles’, as
# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 375
Satchkov
discussed by Soros.6 The only way to Basel VaR testing. The traffic light test,
distinguish a burst of the bubble from also called the binomial test, is based
a ‘test’ is ex post. on the idea that, with a large enough
Figure 5 repeats Figure 1, but with sample, an adequate VaR model should
the instability VaR added. Instability have the percentage of its violations
VaR clearly showed increased risk being close to 1 per cent for the 99
starting in July 2007 and did not per cent confidence VaR.
decrease despite numerous minor rallies It is obvious from Table 1 that both
and some ‘lull before the storm’. The EW and DTW methods show
performance of the EW and DTW in significant deficiencies in all periods.
this period was already discussed. Instability VaR, on the other hand,
shows good results for all periods, even
STATISTICAL TESTING the most challenging ones for a risk
The results of the testing are model, such as the one from the end of
summarised in Tables 1 and 2. Table 1 2006 to the end of 2008.
shows the percentage of time that the Finally, Figure 3 shows the statistical
actual return for the S&P 500 breaks test based on the likelihood ratio (LR)
through the 99 per cent VaR band. suggested by Kupiec.12 LR is given by
This test is based on Basel traffic light the following formula:
test11 but we will use a much bigger
sample that encompasses different
portions of the cycle to avoid the ð1 qÞnv qv
LR ¼ 2 LN ð6Þ
deficiency of the short sample in the ð1 rÞnv r v
376 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)
When swans are grey: VaR as an early warning signal
# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 377
Satchkov
Table 2: Actual number of violations along with 10 per cent (5 per cent on each side) confidence
range
Number violations (significance)
10% confidence
Period bound EW DTW Instability
31st December, 2005 to 21st May, 2010 From 6 to 18 33 32 17
31st December, 2001 to 21st May, 2010 From 12 to 30 40 44 21
31st December, 1997 to 21st May, 2010 From 22 to 42 55 60 26
31st December, 1993 to 21st May, 2010 From 30 to 54 82 83 47
26th April, 1989 to 21st May, 2010 From 40 to 68 97 103 55
31st December, 2006 to 31st December, 2008 From 2 to 9 24 18 8
378 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)
When swans are grey: VaR as an early warning signal
# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 379
Copyright of Journal of Risk Management in Financial Institutions is the property of Henry Stewart
Publications LLP and its content may not be copied or emailed to multiple sites or posted to a listserv without
the copyright holder's express written permission. However, users may print, download, or email articles for
individual use.