Morgan Stanley’s VaR Telling us the Market is Less Risky. Someone tell Google

What do you have when you take a useless idea and make a slight change? Like starting with a 0 and then doubling it, or tripling it, or multiplying it by 100 – you’re still left with 0. They say there’s no stopping an idea whose time has come, but it seems like it’s awfully hard to kill ideas whose time has passed.

Speaking of which – remember when JP Morgan suffered that huge trading loss earlier this year? Remember how turned out that they were using a measure called Value at Risk (VaR) with a few changes the way they calculated it, but after their losses they decided to revert to the older model? It looks like the lesson still hasn’t been learned. FT Alphaville has the breakdown:

Buried in Morgan Stanley’s decent third-quarter results (excluding the absurdity that is DVA of course) is this intriguing footnote:

“Morgan Stanley’s average trading Value-at-Risk (VaR) measured at the 95% confidence level was $63 million compared with $76 million in second quarter of 2012 and $99 million in the third quarter of the prior year. The Firm modified its VaR model this quarter to make it more responsive to recent market conditions.”

The folks over at FT Alphaville have also assembled a handful of great charts to show how the new calculation of VaR “lowers” Morgan Stanley’s risk.  Or more correctly, lowers the amount of risk Morgan Stanley believes is inherent in their positions at the 95% confidence level.  But let’s be completely serious for a moment: does anyone really believe that their risk is that much lower now than it was? They’ve essentially made a tiny change to their calculations (changing how many years back it looked) and voila! The world is now safer! And if you believe that, we’ve got some land in Florida to sell you, too.

But setting aside the fact that these banks are creating a shifting target by constantly updating their models, we’re left with an even bigger question – is anyone convinced that the VaR models are actually a useful measure of risk in the first place?

If we look at VaR in a little more simplistic way (and not entirely correct statistically, but good enough for an example) –  there is a 95% chance they won’t lose more than $60 million dollars in a day, and a 5% chance they will lose more than that in a single day. Problem is – this sort of risk model says nothing about how much could be lost on the rare 5% of cases where things go wrong in a hurry. Does anyone find that reassuring? Or can we finally agree to put some more robust risk metrics in place?

2 comments

  1. Taleb’s book offers a similar assessment of VaR’s usefulness. Remember the natural gas move that killed Amaranth a few years ago? It was reportedly a 7-sigma event, statistically impossible according to traditional VaR analysis. Yet it happened. VaR’s failure to take vital factors like market liquidity into account is a major shortcoming.

    On a personal note… The managed futures performance and risk tool I’m releasing next year (www.eManagedAccounts.com) will include daily and real-time VaR. There’s significant demand for this type of analysis despite the controversy surrounding it. Many investors and risk analysts readily concede that VaR’s “confidence intervals” aren’t to be trusted. Some of them even see no merit in the numeric value of the VaR statistic itself. Where they do see value, however, is in the net change in VaR from day to day or week to week. If a manager’s VaR regularly chugs along at 2.5% for a few months and then suddenly spikes to 4.5% one day, it’s not necessarily a sign of a problem but it’s certainly a red flag. It’s a good excuse to drill down into the manager’s current trades and positions and gather more information.

    Taleb would most certainly disagree with this premise. He feels that VaR is not only useless, it’s worse than useless. And indeed he’s probably right if it’s used as one’s primary risk metric. But when tracking hundreds or thousands of accounts simultaneously, investment companies do find some value in having an alert-able statistic that flags unusual changes in market exposure.

  2. Statistically, there’s also the Estimated Shortfall metric that usually comes along VaR numbers. It attempts to measure the size of the black holes that lie in the 5%.
    No measure is perfect, we know it. Some are even worse than we think: see David Harding’s article about Max Drawdown as a risk metric.
    Risk has to be defined in multiple dimensions, using diversified methodologies and has to be managed at all possible levels. Risk management is more important than risk measure: one could never compute their own VaR and compare it with competitors, yet take less underlying risk than them by proactively managing exposure.
    In the end, gross exposure is risk.

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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

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