Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Importance of better risk models

I have been writing for some time now about better risk models (my
SSRN paper is here and my blog
post on that paper is here). Phorgy
Phynance
has a fascinating graph about the difference between the
normal distribution and a fat tailed (stable) distribution in
computing the 1% daily VaR for the S & P 500 going back 80 years
(hat tip Felix
Salmon
).

His second graph shows that using stable distributions would not by
itself have provided any better warning during the boom years of
2005-2007. But the early warning that it provides from early 2007
onward is truly impressive. During 2007-2009, the stable distribution
VaR gives about 6-9 months advance warning about where the normal
distribution VaR will be. In the world of financial markets, that is
more than enough warning even if you were holding a bunch of illiquid
stocks.

This also means (via the Merton model) that one would have had
several months advance warning of corporate credit market
stresses. That good models are better than bad models might look like
an obvious statement, but too many people that I talk to seem to have
convinced themselves (or let Taleb convince them) that all models are
useless in times of crises.

But the performance of even the stable distribution during
2005-2007 highlights the need for using data going back several
business cycles. This is also a point that I emphasize in my paper.

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One response to “Importance of better risk models

  1. phorgyphynance August 8, 2009 at 2:09 am

    Hi Professor Varma. Thanks for the kind words.

    Have a great weekend!

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