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Auditing Derivatives: Value at Risk

Auditing Derivatives: Value at Risk

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Published by Jasvinder Josen
VaR is getting a lot of negative press lately. However this tool is likely to stay in the market for quite a while. This article suggests what a an auditor should be concerned about in an investment bank, when it come to VaR.
VaR is getting a lot of negative press lately. However this tool is likely to stay in the market for quite a while. This article suggests what a an auditor should be concerned about in an investment bank, when it come to VaR.

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Published by: Jasvinder Josen on Mar 31, 2011
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This article appeared in The Malaysian Accountant journal,Jan-Feb 2011 issue 
Auditing Derivatives: Things that can go wrong – Value at Risk
By Jasvin Josen
Introduction
Value at Risk or just “VaR” has been around for many years and is a major risk managementtask of any investment bank. VaR has not been receiving good press lately, especially whenit was accused for not foreseeing the 2008 crisis. In this article, we will analyse what can gowrong with value at risk and discuss the auditor’s approach.
What is Value at Risk
VaR is a technique for predicting the maximum losses from a portfolio of assests with aknown level of confidence. For example, VaR might predict with a 95% confidence level thatthe maximum losses from a portfolio of risky assets would be RM 100,000. The effectivenessof this tool is in its ease of comprehension, making it a commonly used figure inboardrooms, with regulators and in annual reports.VaR was developed as a risk assessment tool in the 1990s, driven by the failure in the risktracking systems used in the early 1990s to detect dangerous risk taken by traders. Itbecame so widely accepted that regulators like the Basle Committee allowed banks tocalculate their capital requirements for market risk with their own VaR models, using certainparameters provided by the committee.Trades in any portfolio may consist of stocks, bonds, commodities, currency trades orderivatives. Their mark-to-market values will change depending on how the market factors(equity prices, interet rates, currency rates...) change. VaR attempts to develop techniquesto change these market factors in a robust manner, to observe the possible changes to theportfolio value.Three main basic methods are used – historical simulation, variance-covariance and MonteCarlo simulation. Briefly,
 
the historical simulation approach looks back at previous market factors behaviourand applies that same behaviour into the current portfolio to observe the changes inportfolio value.
 
 
in the Monte Carlo approach the market factors are simulated according to a definedstatistical distribution. Then the simulated market factors are applied to the currentportfolio to observe the changes in value.
 
the variance-covariance approach works differently. It derives historical riskmeasures like standard deviation and correlation for each market factor. Then itapplies these risk measures to the current portfolio, (after breaking down theportfolio into standard instruments) to derive the value at risk.
What can go wrong in using VaR?VaR cannot sense a catastrophic event as it pays attention to ‘normal’ loss and not‘abnormal’ loss
It is said that VaR is a measure of ‘normal’ market risk. But what is normal? If one says thatthere is a 5% probability that a portfolio will not lose more than $100,000 in the followingweek, how sure are we that this is a normal loss? The choice of the confidence level is opento interpretation.Joe Nocera of New York Times (Jan 4, 2009) suggests that VaR was useful to risk experts butnevertheless exacerbated the crisis by giving false security to bank executives andregulators.The 2008 crisis dealt with new products like the Credit Default Swaps. These productsgenerate small gains and very rarely have losses. But when they do have losses, they arehuge. As such, it was outside the 99 percent probability and did not show up in the VaRnumber as “it was lost in the tails”.Some critics claim that VaR looks at only a small slice of the risk and a great deal of valuableinformation in the distribution is ignored. Manageable risk near the centre of thedistribution is focussed on and the tails are ignored.
What does the Auditor do? 
Depending on the level of importance that is placed on VaR in a firm, the auditor shouldobserve if risk managers have a clear comprehension of all the important confidence levelsand are able to place enough importance to them.
Ignoring important risks -- contagion and liquidity
Nassem Taleeb (the writer of “The Black Swan”) is concerned with what one callsmeasureable risks. “Measurable risk is when you have a handle on the randomness. If Ithrow a pair of dice, for example, I can pretty much measure my risk because I know that Ihave one-sixth probability of having a three pop up. Non-measurable uncertainty is when
 
I'm throwing the dice without knowing what's on them. In the real world, most social eventsare non-measurable because nobody hard-coded the rules of the game”VaR attempts to measure only market risk – the risks that directly change the value of financial instruments in the markets. But there are other risks which are just as important –contagion and liquidity.Although VaR models take into account the increased risk brought on by leverage, it fails todistinguish between leverage and liquidity risk – borrowed money market instruments canbe called in at any time and cause a major liquidity crisis. Liquidity crises can do seriousdamage to dynamic hedging to rebalance the portfolios – a major panic that dries upliquidity will cause unreasonable bid-ask spreads, making hedging extremely difficult.The contagion effect which happens in no certain pattern in periods of market stress willbreak down correlations assumptions in VaR models, particularly the variance-covariancemodel.
What does the Auditor do? 
The auditor must watch for the extent of leverage in the firm and market to deduce theappropriateness of VaR to interpret risk. He could discuss with management to assess theimportance placed on contagion and liquidity risk which are not measureable butdetrimental to the market and economy.
Relying on the wrong past
This is the problem of the historical simulation where the prior N days from which thehistorical sample was drawn upon is not representative of the present. One cannot beconfident that errors of this sort will “average out”.Traders will know whether the actual prices changes over the last 100 days were typical, andtherefore will know for which position the VaR is underestimated or overestimated. If VaR isused to set risk or position limits, the traders can exploit their knowledge of the biases in theVaR system and expose the company to more risk that the risk management committeeintended, creating an incentive to take “excessive but remote risks”.
What does the Auditor do? 
Alertness to industry and market knowledge will prompt the auditor to have considerableintuition of the appropriateness of the past data to represent the present. In times of disagreement, he should take it up with management.
Wrong distribution assumption

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