The Next 10 VAR Disasters
Aaron Brown, professor at Yeshiva University, predicts how VAR is
likely to be used and abused
During World War II, England's Royal Air Force was losing too many airplanes as they landed in bad weather. Some physics professors had an idea that
might help-microwave glide-path radar. Early results showed that the system
was a major aid to pilots. But in a famous test, the system mistakenly tried
to land an airplane in the Atlantic ocean, 20 miles from the airfield. It
did not help that a skeptical general was observing the test aboard the
In the last 50 years, microwave glide-path radar has saved countless
lives and airplanes. But it created new kinds of disasters. No human pilot
would try to land an airplane in the ocean. New technology is always subject
to spectacular disasters-spectacular because they are different from familiar
The same high-tech problem applies to Value-at-Risk. It is being pushed
on just about every derivatives user by the Bank for International Settlements,
the Federal Reserve Bank and the Securities and Exchange Commission. Like
microwave glide-path radar, it is a useful tool that will prevent many disasters.
But before it becomes familiar and well-understood it will land some airplanes
under a thousand feet of saltwater. Even if the new system saves 10 airplanes
for every crash it causes, the crashes will be remembered far longer than
Here are some of the mistakes I see just over the horizon.
Disaster One: Living By VAR Alone
Inevitably a trader will be asked: "How could you lose $100 million when VAR was only $10 million?"
The simple answer is that VAR does not measure the worst-case loss, but
the loss you have some specified probability of exceeding. So there will
be losses greater than the VAR. Moreover, VAR assumes passive management
over short periods. With active management over longer periods, larger losses
If VAR is part of a well-designed and validated risk management system
it should prevent catastrophes. But some institutions are using VAR to replace
traditional limits on nominal size, delta and gamma. VAR cannot be used
as the sole measure of risk. If it is, aggressive traders will find ways
to keep VAR risk within limits while boosting risks VAR ignores.
Disaster Two: The Delta Blues
An institution that understands the risk of Disaster One will decide
to implement VAR limits and retain its delta limits. But the trader will
be unable to meet both limits at once.
This will happen when a company decides to hedge its natural long-term
exposure by rolling short-term contracts. In market shocks, short-term volatility
increases much more than long-term volatility. VAR increases in proportion
to short-term volatility, and VAR limits can be maintained only by reducing
position amounts. The market shock will also reduce the correlation between
the long-term natural position and the short-term hedge. As a result, the
delta limits will demand a larger hedge position just as the VAR limits
demand a smaller one.
Traders at Metallgesellschaft hedged long-term oil supply contracts with one- to three-month oil futures. When oil prices jumped they faced a dilemma.
Increasing, or even maintaining, their hedge would cause huge short-term
cash losses. Yet reducing their hedge risked even larger long-term losses.
The problem is that VAR looks at the short-term risk of an unmanaged
position, while delta considers the long-term economic fundamentals. In
a market upheaval, these usually point in opposite directions. It is analogous
to a traffic emergency. The VAR philosophy, since it is computed on an unmanaged
position, assumes you cannot steer. Therefore, it always recommends hitting
the brakes. Yet in some situations, accelerating gives you more control
over the car. The only solution, in finance and driving, is to have a strategy
for dealing with emergencies. Either try to steer your way out or shut your
eyes, hit the brakes and hope for the best. But don't try both at once.
Disaster Three: The Chicken Little Syndrome
A corporation will see VAR rising for several weeks before a major loss. The officers will be criticized for doing nothing to stop the rise. One
business magazine will call it "Asleep at the Switch," while another
will scold "Fiddling While Rome Burns."
When VAR rises, responsible managers will determine whether the cause
is internal or external. They will alert key personnel, clarify lines of
authority and verify reporting systems. They may increase liquidity or eliminate
speculative positions. One thing they should not do is insist on a reduction
Consider two investors, A and B, in an S&P 500 index fund. A invests a constant amount, while B maintains a constant VAR. A never buys and sells,
while B moves some funds to money markets when market volatility is high
and margins up when volatility is low. If A and B maintain the same average
investment, B will have 25 percent more standard deviation of long-term
return. Once VAR goes up, it is too late to get out by blindly slashing
Disaster Four: Jumping Ship Too Soon
A CEO, frightened by rising VAR numbers, will order VAR reduced-by slashing positions. VAR may be reduced in the short term, but it may not stay down
as the reduced portfolios are managed.
There are times to reduce VAR as a long-term strategy, but not as a reaction to yesterday's market movement. You can reduce the VAR limit of each portfolio
segment, but this works only if the segments are highly correlated or if
losses are "leptokurtotic," that is, if big losses result from
disasters in one segment rather than the cumulative effect of smaller losses
in many segments. Both of the above situations, however, are undesirable.
Sensible reduction of VAR is a subtle, long-term process. It requires
understanding the rationale of each segment of the portfolio and how the
segments fit together. And getting from a $10,000,000 to a $5,000,000 VAR
may require a temporary stopover at $15,000,000 VAR.
Disaster Five: The Mirror Has Two Faces
A corporation will try to compute VAR on its financial portfolio combined with the underlying hedged assets and revenues, a common approach. But it
will still be surprised unexpectedly by market crises-and will hear alarm
bells when things are OK.
How could this happen? A company may hedge long-term Deutsche mark (DM)
revenues by using rolling short-term futures contracts. Reported VAR will
be small since the corporation regards any losses in the futures position
to be offset by corresponding gains in their natural position. Reported
VAR will thus give no indication of short-term risks; therefore the corporation
will have no warning of market crises.
Small changes in the relative shapes of the U.S. dollar and DM yield
curves will cause VAR to increase sharply, however. VAR will ignore the
true risks but set off alarm bells for phantom risks.
Disaster Six: The PR Problem
Another corporation that understands the problem of phantom risks will
compute VAR only on its derivatives portfolio. This too will turn out badly.
At first, the CFO of this corporation will consider VAR a valuable tool
for measuring liquidity and capital risk. VAR will give early warnings of
portfolio problems and market crises, and it will make it possible to compute
the risk-adjusted costs of various hedging strategies.
But other people will be horrified that VAR is larger than net income
or even stockholders' equity. The CFO will appear to be risking the financial
stability of the company on derivatives bets. When VAR goes up, analysts
will ask how the company will reduce it. They will be shocked to learn that
there will not be a reduction. The result: an investor-relations fiasco.
The truth is that many corporations are already uncomfortable with derivatives reporting. Asking them to mark positions to market is like asking a shy
person to take off his shirt in public. VAR is like asking them to get naked.
Disaster Seven: The Double Whammy
The managers of a bank will implement VAR on their trading portfolios
but not on their hedge portfolios, another common practice. The bank will
thus set itself up for a double disaster.
Hedge portfolios contain deals done with customers partially offset with marketable positions taken to reduce risk. Proprietary trading portfolios
are run for speculative profit. The customer portion of the hedge portfolio
cannot be managed. The bank must quote prices and allow customers to cash-out
in any market but cannot ask its customers for these courtesies. In a market
emergency, the customers will be trading frantically and the bank may not
be able to lay off risk at a reasonable price. The VAR of the hedge portfolios
At the same time, the VAR of trading portfolios will increase because
of increased volatility. Proprietary traders will have to reduce positions.
There is a 50-percent chance that the forced reductions will be contracts
that would have offset the risks of the hedge portfolios.
Suppose, for example, that interest rate volatility increases and the
bank's customers want to avoid floating rate payments. They cash out of
their fixed-for-floating swaps and buy new floating-for-fixed swaps. The
hedge portfolio finds itself long interest rates; it loses money if interest
rates increase. But the yield curve has steepened and bid/ask spreads have
increased, so this risk cannot be reduced without losses. Meanwhile, the
proprietary traders have correctly foreseen this steepening and are short
interest rates. This is a natural hedge for the bank. But the increase in
interest rate volatility forces proprietary traders to liquidate this position.
The final result: interest rates go up. The hedge portfolios lose because they couldn't lay off risk from customer trades. Proprietary traders have
no profits, because they sold the positions that would have offset the hedge
Disaster Eight: Too Much See, Not Enough Saw
Another bank will realize the risk of Disaster Seven. It will implement
VAR on its trading portfolios and hedge portfolios combined. Proprietary
trading profits will plummet.
Why? In normal markets the trading portfolio will have most of the VAR,
but in a crisis hedge portfolio VAR will increase. If VAR limits are to
be maintained, the proprietary traders will effectively be enlisted to hedge
the hedge portfolios. Proprietary traders do not earn bonuses in quiet markets.
They need risk to make money. Tying their hands in violent markets eliminates
most of their opportunities for profit.
It may seem that corporations and banks are damned if they do and damned if they don't. This is not the case. Different systems for VAR computation
can make sense as part of overall risk management plans. But a strategy
must be set in advance to manage limits under all conceivable market scenarios.
Otherwise, VAR can end up reducing profits and increasing risk.
Disaster Nine: Enter the lawyers
A stockholder will file suit over VAR. The suit may allege that management misrepresented risk by disclosing a small VAR, or concealed risk by not
disclosing a large VAR. Management could be accused of negligence for ignoring
VAR, for relying on VAR or for not computing VAR at all.
VAR, like any other useful number, is a compromise between what we want
to know and what we can measure accurately. We would like to know the actual
probability of worst-case losses. But catastrophic losses are too rare,
and active portfolios are too complicated, to be analyzed reliably. So we
settle for VAR and hope it indicates the overall level of risk.
Implementations of VAR often make adjustments to make it closer to a
worst-case loss number. Conservative assumptions may be made about correlations
and volatility changes. Statistical methods that weigh extreme events too
heavily may be chosen.
On the other hand, VAR computations often include assumptions that tend
to reduce the reported number. Volatilities and correlations may be considered
constant. Skewness and kurtosis may be ignored. Illiquid securities may
be modeled as actively managed portfolios of liquid securities. Certain
types of risk and certain portfolios may be excluded from VAR.
The result is a number that is different from VAR computed by any other
institution. It will not correspond to the technical definition, nor will
it be the worst-case number many people will think it is. In some market
scenarios it will overstate risk, while in others it will understate risk.
A good lawyer can make any of these assumptions or adjustments look like
Board and management responsibility for derivatives risk is an unsettled area of law. VAR was originally designed outside the framework of existing
legal theory, and then was suddenly thrust in the middle of it by regulatory
agencies. Is management responsible for maintaining a stable VAR? Keeping
VAR low? Fully disclosing VAR? Acting on VAR information? Understanding
VAR? Ensuring VAR is accurate? Ensuring VAR is conservative? Nobody knows,
but it will be expensive to find out.
Disaster Ten: The Next Generation
Disasters One through Nine will pave the way for a new risk measure,
premium- equivalent (PE). A reinterpretation will show that every trader
who was good under VAR is now terrible and the people who flopped under
VAR really were great.
Say you want to know the risk of your house burning down. Statisticians
tell you to survey 1,000 similar houses. Finance professors tell you to
get a fire-insurance premium quote. Statistical methods estimate probabilities
by sampling. Financial methods determine how much someone would charge to
assume the risk.
Five years ago, financial measures such as option-adjusted spread were
popular. They depend only on observable prices, not guesses about probability
distributions or time series properties. They give precise answers; two
people with the same complete price data should give the same financial
risk measures. Also, financial risk measures can be added across portfolios.
The risk of a portfolio is the sum of the risks of its parts.
Financial risk measures do not measure the probability of risk directly, however. Large risks with zero betas will not show up because one theoretically
could get someone to accept this risk for nothing. Also, they only measure
what the market "thinks." Many regulators are concerned about
what happens if the market is wrong.
Statisticians fought back with VAR and similar schemes. Compared with
financial measurements, these encourage high beta risk, doing what everyone
else does. VAR assigns equal risk to being long or short the S&P 500
while financial measures assign a higher risk to being long. The statistician
will argue that the probability of short-term losses for both the long and
short positions are equal. The finance professor will argue that there is
unlikely to be a liquidity crisis if the stock market goes up sharply.
Both arguments have some truth to them, and sensible risk management
policies have always combined both approaches. But regulators have their
fads and fashions. Today's wisdom rewards those who follow the crowd; tomorrow's
wisdom may celebrate the contrarian.