SERVING THE QUANTITATIVE FINANCE COMMUNITY

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teaplus1
Topic Author
Posts: 6
Joined: December 16th, 2013, 8:41 am

### Measuring risk

Try googling the phrase "measure risk". When I do this I only see links from the financial world, although "risk" is a general word which applies to lots of other things. Why?When I criticize mathematical risk models such as VaR, people typically reply "...yes, but...what is the alternative? We have nothing better". But look to the rest of the world - no one seem to try to "measure" the risk of war, the risk of breaking a leg while skiing, the risk of walking into a dark alley in the wrong side of town, etc. (At least not with the precision of several decimal points!)What is so special about finance that induces us to "measure" risk while we seem to tackle other risky situations by (vaguely) being careful and staying away from trouble? Let me know what you think ...

Martinghoul
Posts: 3256
Joined: July 18th, 2006, 5:49 am

### Measuring risk

Who says that we don't try to "be careful and stay away from trouble" in finance? Also, just because our risk measurements in everyday life happen to be implicit, approximate and based on potentially flawed heuristics, doesn't mean that we aren't "measuring".

MHill
Posts: 489
Joined: February 26th, 2010, 11:32 pm

### Measuring risk

Decimal points depend on the accuracy of your inputs and your calculation engine. The risk of breaking a leg while skiing is thoroughly measured by insurers. That's why they charge an extra premium for winter sports. I can view the output of the calculation to two decimal points. There is a lot of input data, and someone has spent time looking at how to calculate this.The risk of war is also measured, maybe as US investor sentiment as Russia intervenes in the Crimea. People are watching and deciding whether or not to pull out money. That implies a probability weighted calculation.If I lived in Ukraine, I would be trying to work out whether to stay or go. The calculation wouldn't be exact, but I'd be calculating where I would be better off on a probability weighted basis. I wouldn't have nice numeric inputs, or a sophisticated calculation engine, so I would expect a large margin of error. I'd hope the result of my calculation was sufficiently decisive that I didn't need to worry about the margin of error. Similar for the dark alley.

rmax
Posts: 6080
Joined: December 8th, 2005, 9:31 am

### Measuring risk

Agree with the points so far. The difference I think is that in Finance we are transferring risk around for a premium - hence why it is helpful (although not a prerequisite) for a price - hence there is the false comfort of a string of numbers on a screen somewhere. Insurance covers risk so is somewhat similar. The other risks are inputs into decision trees, however the risk would still be measured. Think of it this way: Did the US not weigh up any risks when they went into Gulf War I compared to Crimea? Did I not weight up the risks when I bought my house?

farmer
Posts: 13479
Joined: December 16th, 2002, 7:09 am

### Measuring risk

QuoteOriginally posted by: teaplus1What is so special about finance that induces us to "measure" risk while we seem to tackle other risky situations by (vaguely) being careful and staying away from trouble? Let me know what you think ...I can think of three areas where we handle other people's money: Finance, family, and politics. In family, the monitors are incompetent, and there is no way to change advisers anyway. In politics, the monitors and the advisers are the same entity, and so the US Constitution recognizes there is no practical way to stop them from lying. That leaves only finance where there is some need to communicate risk from advisers to monitors in a standardized way.

Paul
Posts: 10837
Joined: July 20th, 2001, 3:28 pm

### Measuring risk

In 'real' life we tend to use worst-case scenarios a lot. Even if only estimated intuitively. I've tried to encourage more of this in finance. The probabilistic approach is not often relevant for individuals. I'm sure governments work with probabilities all the time...but I can imagine some doesn't get much publicity...when it comes to nuclear power stations, transport, health, wars,...people only want to hear that things are 100% safe!The risk of rainfall is quantified in weather forecasts.P

DavidJN
Posts: 1766
Joined: July 14th, 2002, 3:00 am

### Measuring risk

Gambling has been around and studied a lot longer than high finance. The outcome of your google search is most likely related to Big Brother's attempt to maximize revenue rather than provide a genuinely useful search engine.

quartz
Posts: 427
Joined: June 28th, 2005, 12:33 pm

### Measuring risk

Besides insurance, Enterprise Risk Management is getting calculated better and better, does that count as finance or other things? And we just did not have the data yet, while I bet you'll start hearing about Big Data a lot now. They're selling monitoring devices and risk measurement systems for babies, ill people, elderly, sportsmen, industrial machines, cars, home appliances etc...And hey, that strange gray thing inside the skull is a risk managing device too! That he's not informing and distracting your conscious activities all the time does not mean it's just vaguely careful.

tw
Posts: 1176
Joined: May 10th, 2002, 3:30 pm

### Measuring risk

QuoteOriginally posted by: teaplus1Try googling the phrase "measure risk". When I do this I only see links from the financial world, although "risk" is a general word which applies to lots of other things. Why?When I criticize mathematical risk models such as VaR, people typically reply "...yes, but...what is the alternative? We have nothing better". But look to the rest of the world - no one seem to try to "measure" the risk of war, the risk of breaking a leg while skiing, the risk of walking into a dark alley in the wrong side of town, etc. (At least not with the precision of several decimal points!)What is so special about finance that induces us to "measure" risk while we seem to tackle other risky situations by (vaguely) being careful and staying away from trouble? Let me know what you think ...IMO it is because "risk" is not necessarily a negative thing in finance. Other things being equal one prefers lower risk to higher, but other things are rarely equal.

teaplus1
Topic Author
Posts: 6
Joined: December 16th, 2013, 8:41 am

### Measuring risk

Good point - btw: the prime brokers I have worked with (Goldman Sachs, UBS, Morgan Stanley) all use a combination of simple worst-case scenarios ("what if all stocks fall X%", "what if your 5 greatest positions fall Y%", "what if the least liquid stocks fall Z%", etc) to find margin requirement for hedge funds. No mention of VaR, standard deviations, correlations, ARCH, GARCH whatsoever.

farmer
Posts: 13479
Joined: December 16th, 2002, 7:09 am

### Measuring risk

teaplus1
Topic Author
Posts: 6
Joined: December 16th, 2013, 8:41 am

### Measuring risk

"If, as a customer, you told your broker what the worst-case scenario is for your portfolio, he would not waste his time reading the email"Yes, of course. But I'm talking about a prime broker relationship where all assets are in custody of the bank, so it is not an issue of trusting the VaR numbers we report. They don't rely on any analysis from us, they have the opportunity to analyze the portfolio just as well as the investment manager has. Yet they don't do any of the risk "measuring" I mentioned, they rely on a set of crude worst-case-scenarios when they offer credit to hedge funds.

xpatagon
Posts: 54
Joined: June 1st, 2011, 1:31 pm

### Measuring risk

QuoteOriginally posted by: teaplus1, they rely on a set of crude worst-case-scenarios when they offer credit to hedge funds.They lending, not investing, so they are not protecting against mark to market changes but against the possibility of default. Hence, measures like VaR dont make a lot of sense because the lender is only interested in tail events (ie that they cant pay), and VaR doesnt even pretend to say anything useful about tail events.Your examples of simple worst case scenarios seem to me to be generally aligned with what little I can remember of the BIS guidelines for stress testing. If you look at the rules for clearinghouse solvency for example, one of the standard models for clearing house risk is to look at the effect of what happens when the n largest contributors simultaneously default, which is more or less your example of the 5 greatest positions falling x%

daveangel
Posts: 17031
Joined: October 20th, 2003, 4:05 pm

### Measuring risk

QuoteOriginally posted by: teaplus1"If, as a customer, you told your broker what the worst-case scenario is for your portfolio, he would not waste his time reading the email"Yes, of course. But I'm talking about a prime broker relationship where all assets are in custody of the bank, so it is not an issue of trusting the VaR numbers we report. They don't rely on any analysis from us, they have the opportunity to analyze the portfolio just as well as the investment manager has. Yet they don't do any of the risk "measuring" I mentioned, they rely on a set of crude worst-case-scenarios when they offer credit to hedge funds.the PB does not own the stock - he is lending you money against it. for him the worst case is that the stock drops and you cannot pay him back the loan amount so he looks for the worst case.For me, given that we have limited capital then we have to look at risk to allocate capital effectively.
Last edited by daveangel on April 7th, 2014, 10:00 pm, edited 1 time in total.
knowledge comes, wisdom lingers

Posts: 23951
Joined: September 20th, 2002, 8:30 pm

### Measuring risk

The precision of financial risk calculations may be several decimal points, but what about the accuracy? Can we really say that the discrepancy between, for example, implied volatility and realized volatility is somewhere deep in the Nth decimal place? How accurate are the estimated default rates or recovery rates? Most people and especially managers, investors, and regulators want certainty. And all these mathematical models and advanced algorithms seem designed to appear to satisfy the itch for getting another decimal point even if they they fail in practice.There are other ways to look at risk. In the Enterprise Risk Management world mentioned by quartz, some methodologies simply skip the estimation of likelihood and impact because they are virtually incalculable (at best, they might use a subjective ranking of a few of the "major" risks). The worst case is ALWAYS a total loss and the range of estimates of likelihood could vary by orders of magnitude (i.e., the number of decimal points of accuracy is effectively negative). For corporate risks, there are simply too many potential causes (obscure dependencies), too many power-law tails (earthquakes), too many novel cascades of failures (Iceland volcano), and too many ongoing changes in the risk landscape to accurately manage it all. Surveys of risk perceptions and maps of risk intensities show how poor the estimates are -- a depressingly larger percentage of crisis events fail to follow the expected locations and timings predicted by expected likelihood calculations.Instead of nailing down another decimal point on the expected value of risk, some ERM approaches emphasize reusable preparations for responding to events. That is, they emphasize business continuity plans, some amount of redundancy, and some amount of training/drills so that people know what to do when fecal-turbine collisions occur.

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