No Country for Old Risk Models
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Introduction (Via Financial Tech)
Congress, economists and taxpayers agree on one thing: Large financial firms cannot continue to make large, risky bets (on highly leveraged subprime-related CDOs and CDSs, for example) and expect a government bailout. Survival in 2010 will hinge on taking risk management processes and technology more seriously.
Excerpt (Via Financial Tech)
Wall Street needs to put more-sophisticated models in place next year, argues John Lietchy, associate professor of marketing and statistics, Pennsylvania State University. “Firms can benefit from more-sophisticated time series models of correlation structures and dependence structures between market places,” he contends. “One major firm does its Value at Risk calculations using a four-year rolling window — they just go back four years and every day they throw one day off the end of the pile and add one onto the front. An event can roll through for four years, and then suddenly it’s gone.” Further, VaR models often don’t account for the extreme correlations that occur during a market crisis or a disruption, Lietchy adds.
But Paul Wilmott, a researcher, consultant and lecturer in quantitative finance, cautions against too much model sophistication. “The more sophisticated your tool, the greater potential for pretending there’s no risk,” he says. More important is to have risk managers question existing models and apply real-world knowledge to them, Wilmott asserts.
Able Alpha Trading’ Aldridge says she expects to see risk management advances in the areas of portfolio management, high-frequency trading and the risk ratings of loans.
