Value at Risk –A Critical Analysis and the Emergence of New Risk Measures

Value at Risk –A Critical Analysis and the Emergence of New Risk Measures

Risk management tools for market risk are largely based on Modern Portfolio Theory and assume that the profit and loss (or the return) distributions are “Normal” . In a “Normal” scenario, the standard deviation of the portfolio returns is a good risk measure, and efficient portfolios are the ones generating the best mean-variance profiles.

To measure risk under very generic conditions- “Normal” scenario, the concept of Value at Risk (VaR) was introduced.

However, statistical data show fat-tailed and asymmetric distributions for market returns too. The fat-tail represents the risk that the portfolio value can be affected by large movements in the market prices.

Therefore models such as Capital Asset Pricing Model, Arbitrage Price Theory, and VaR which are developed under the assumption of normal distribution lead to misleading results.

The intent of this paper is to analyze the advantages and drawbacks of VaR and introduce some of the new risk measures that are gaining ground.

Introduction

What the world is witnessing over the past 12-18 months is unprecedented in history. Banking behemoths like Lehman Brothers and Bear Stearns that were considered infallible have fallen like nine pins. The entire financial landscape has undergone a structural shift and it will be never the same again.The reasons for the crisis are as many as the people analyzing it. Few noted ones are:

• Multifold increase in the volumes and complexity of Credit Derivatives and Structured Products (Figure 1)
• Oversight failure
• Inadequate Governance
• Over reliance on traditional risk measures like VaR

To prevent an irreversible economic catastrophe, the governments across the globe made unprecedented interventions in financial markets.

The financial system faces a number of significant near-term challenges. This paper would review the challenges that Value at Risk (VaR) has posed to the Regulators and Risk Managers and briefly examine some new measures which are appearing on the horizon as alternates to VaR.

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