It’s 10 a.m.; do you know where your money is?

Much more has been written about risk management, investor transparency, and VaR since our inaugural blog in January which discussed whether reliance on VaR contributed to the current economic crisis. That blog focused on the ideas in Joe Nocera’s cover story in the New York Times Magazine that week. As most cover stories focus on politics, foreign relations, human interest, or entertainment, seeing RISK! on the front cover of the magazine that week certainly was a surprise. Over the last three months, the discussion about risk management and VaR has continued, bringing forth more ideas, opinions, and calls for change. A couple of hot topics recently involve the lack of due diligence done by investment advisors who invested client money in the Madoff fund as well as the lack of attention paid by analysts to risk measurements published in the financial statements of banks. Here, I'll look at what's changed since we launched our blog in January and what else you can do to ensure you have an adequate VaR system in place.

Certainly one recent industry event on people’s minds is the Madoff scandal, which Dan diBartolomeo recently spoke about in our podcast series. The Madoff scheme and smaller ones like it have recently prompted many fund of fund managers to require that any fund they invest in have an outside administrator to ensure independence, transparency, and even to calculate NAV. This is a vast departure from current industry practice. Hugo Cox writes about this in the April issue of Alpha Magazine. Key to the understanding of your risk is performing due diligence and making sure that the reported investment performance is accurate. A move in the direction of greater transparency in this area is certainly a positive change that will raise standards in the industry.

On the subject of VaR, Aaron Brown, a risk manager at AQR Capital Management, recently wrote the cover story for the GARP Risk Review titled “Opening the Vault to the Risk Disclosure Data.” He pointed out that not enough attention is paid to the risk information provided in financial statements. Analysts and investors are overly obsessed with quarterly earning to the point where beating or missing the street’s estimate by a couple of pennies can dramatically move a stock. Brown asserts that the reason analysts pay so little attention to the risk disclosures of financial institutions is that the risk information is often too technical for most to understand. He presents two simple alternative risk measures; risk price to earnings ratio (RPE) and risk beta.

One sidebar story within the article titled “Flabby VaR” discussed the characteristics that a VaR measure must possess to be useful. While many VaR measurements will have the correct number of VaR breaks, they will often be set too high or will not respond fast enough to changes in market volatility. For example, your actual daily loss should break a 95% VaR measure 5% of the time or approximately 13 days in a year. If your VaR is broken 12 or 13 times in year, you may think your system if performing adequately. However, if all 13 breaks in the year occur within a single 25 day period of high volatility, it’s time to re-evaluate your VaR measurement so that it more quickly adjusts to short term changes in volatility. It is not at all bad for your VaR measure to surprise you sometimes. Brown maintains that if it does not, it will be the actual losses that surprise you instead. Those surprise often serve as an early warning. So it’s important to dig deep and really test your VaR system. What may look adequate on the surface (such as an appropriate number of VaR breaks) may actually be misleading and what may look like an outlier (such as a surprising increase in VaR) may actually be the exact reason you need your VaR system.

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