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Received (in revised form): 7th June, 2010

Daniel Satchkov

is the President of RiXtrema Inc., a risk modelling and consulting firm that focuses on the extreme financial

market events. Prior to founding RiXtrema, he was an Associate Director of Risk Research at FactSet, where he

was responsible for researching and developing software products in the areas of risk measurement and risk

reporting. He has spoken at numerous conferences and published articles dealing with risk management

issues in such magazines as Journal of Asset Management, Investment and Pensions Europe, as well as in a

number of white papers and an e-book. Daniel’s current research is in the area of extreme market events,

credit cycles and behavioural finance. Daniel holds BS and MBA degrees from the University of the Pacific.

Tel: þ1 (917) 600 9679; E-mail: d.satchkov@rixtrema.com

Abstract The market events of 2008 will be remembered as much for their

extreme volatility as for a widespread failure of the risk management, which

contributed to the near collapse of many firms thought to be among the leaders

in that field. This paper identifies a key deficiency in the way that the historical

data are currently utilised in the estimation of risk. This deficiency stems from

the conception of the marketplace as an equilibrium-seeking and continuous

system and it led to the financial firms’ unpreparedness for sudden market

reversals. A different framework for risk estimation is proposed based on linking

the risk modelling with the existing literature on financial instability. One

possible application of the proposed method to the estimation of value-at-risk

(VaR) is demonstrated, and empirical tests comparing it with the traditional

methods are performed using S&P 500’s history from 1989 to 2010. The new

measure, called the instability VaR, is shown to dominate all traditional

methods of calculation.

risk mispricing, financial instability hypothesis

Market events of 2008 will be significant improvements in the

remembered as much for their extreme performance of risk estimates. This

volatility as for a widespread failure of the analysis proposes a fundamental change

risk management, which contributed to to the way that historical data are used in

near collapse of many firms, had various the estimation of risk. It will show how

causes and went far beyond deficiencies the accuracy of one common metric

in risk measurement techniques. called value-at-risk (VaR) can be

Nevertheless, underestimation of risk significantly improved with the

played a real part and the obvious lesson application of this new method, which is

of that disaster should be that the motivated by the idea of self-sustaining

366 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)

When swans are grey: VaR as an early warning signal

boom-bust patterns and their relation to historical VaR are all different measures

pricing of risk. While the paper will of the risk metric called VaR.

focus on VaR, the ideas presented here VaR has a statistical definition (it is a

are general and can be applied to the quantile of a distribution), and nothing

estimation of any risk statistic. in this definition implies that it has to be

based on a bell curve calibrated

exclusively on recent returns as is the

PROBLEMS WITH CURRENT case with most accepted models today. In

VAR IMPLEMENTATION other words, there are different ways of

VaR is the most commonly used metric measuring the metric called VaR.

of market risk. However, VaR is Extreme value theory methods do not

frequently the subject of criticism, and assume any particular overall distribution

this paper will consider some of the and Monte Carlo simulation VaR can be

arguments against it that carry the most based on many distributions, including

validity. various power law distributions that

The most often voiced objection to Taleb favours.1 These distributions can

VaR stems from the obvious model the effects of the ‘fat tail’, which

inappropriateness of the normal frequently and painfully asserts itself in

distribution for the modelling of the financial markets, although, as will be

medium- to short-term financial returns. seen, there are practical problems with

The fact that the short-term returns are those versions of VaR as well. Lack of

not distributed according to a bell curve awareness of the basic distinction

can be hardly disputed at this point. It is between the measure and the metric

enough to consider the simple fact that sometimes leads to definitions of VaR

daily returns of the S&P 500 display a which state that it is only valid during

kurtosis of greater than 7 over the three ‘normal conditions’. It is astonishing that

years even prior to August 2008. A anyone would even consider using a risk

popular version of this argument against measure that only functions when one

VaR can be found in Nassim Taleb’s does not need it. The goal in this study

Black Swan: The Impact of the Highly is not to discard VaR, but rather to make

Improbable.1 However reasonable it sure it better accounts for the drastic

appears, this argument should not be market reversals that seem to always catch

levelled at VaR as a metric of risk, but quantitative risk systems by surprise.

rather at one particular way of calculating

VaR, namely the parametric or normal THE REAL PROBLEM: EQUAL

distribution VaR based on a particular WEIGHTED AND DECAY TIME

way of incorporating historical data. WEIGHTED ESTIMATORS

This misunderstanding is based on a The main problem that makes the

confusion of the concepts of measure current risk measurement dangerously

and that of the metric. Measure is an inadequate lies not in a distributional

operation for assigning a number to assumption, but rather in the way that

something; there could be many ways of the historical data is incorporated in the

doing so. Metric is the interpretation; for risk estimates. The current methods for

example, VaR is a metric, see Holton.2 using past observations gradually became

Parametric VaR, Monte Carlo VaR and axioms that are completely divorced from

# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 367

Satchkov

the market realities or any new economic estimate leaves the risk analyst completely

thinking. Currently, there are two unaware of what extreme conditions

common methods for incorporating the could do to their portfolio. The

past observations into the estimates of historical data gathered during the period

risk metrics. This paper will call them of moderate or low volatility that

the equal weighted (EW) and decay time persisted just before the crisis will

weighted (DTW). The equal weighted severely understate the risk potential in

estimator of (co)variance (for a normal the market. Problem 2: In addition, the

distribution, which is being used here, equal-weighted estimator adjusts very

the risk and variance are assumed to be slowly to changes in the market

synonymous) is derived directly from conditions and may indicate low risk

statistics where an unbiased estimator of long after it is obvious to even the most

(co)variance is equal to: casual observer that the high-volatility

period has commenced.

1 X

n

EW 2

s j;k ¼ ½r j;i rk;i ð1Þ The DTW estimator is an attempt to

n 1 i¼1 correct the second of these problems by

making the estimate more sensitive to the

where: recent market conditions. The DTW

r j;i — return of asset j or k at time i (co)variance estimate could be written as:

n — number of observations. TDW

The VaR is then calculated as: s2j;k

2 3

VaR ¼ ks j;k ð2Þ Xn 6 li1 r r

6 j;i k;i 77

¼ ð1 lÞ 4Pn 5

where: i¼1 ð1 lÞ l l1

k — scaling based on the confidence l¼1

level of VaR. n h

X i

1

In terms of economics the implicit ¼P

n li1 r j;i rk;i

assumption in the use of this method for ll1 i¼1

l¼1

modelling variability of the returns is that

a system is being observed that is ð3Þ

relatively stable over the time period of

observation and is projected to continue

l — exponential decay factor

l,i — indicators of time

this behaviour into the future period

covered by the risk forecast. This rj,i — return of asset j or k at time i.

assumption seems to be inspired by the It can be seen that in this calculation

economic theories which purport the the more recent periods are meant to

existence of a long-term equilibrium in carry progressively more information

the economic and financial system. and are weighted accordingly. The

Nevertheless, there are two obvious implicit economic assumption can be

practical problems with this approach for understood in relation to the EW

the purposes of the risk estimation. estimator and consists of allowing the

Problem 1: If a sudden crisis erupts market and the financial equilibrium to

after a period of moderate volatility and vary more rapidly with time. The

low or moderate correlations, the risk DTW approach does indeed solve the

368 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)

When swans are grey: VaR as an early warning signal

above. Nevertheless, it cannot fix the meltdown.

more important first problem and still The new paradigm of risk

leaves a risk manager unprepared for measurement must minimise the

the possibility of a sudden change in extrapolation from quiet periods to the

the market structure after a period of tails of the distribution. A market

moderate volatility and correlations. In structure during the extreme event is

other words, although it allows for likely to be drastically different from the

changes in the market structure, it is one observed in the trading range or even

still only a reflection of the presently in the moderate volatility periods before

observed volatility and assumes a the crisis. Incorporating this fact does not

certain continuity that is simply not necessarily mean that a financial firm

observed in practice. should be permanently braced for the

As an example, consider Figure 1. In it crisis, an approach that would be neither

can be seen S&P 500 returns and the practical nor healthy for the economy.

two methods of estimating 99 per cent Instead one should look for ways to

VaR for the S&P 500, one using the EW correct the assumptions embedded in the

method and the other using the DTW current process to improve the accuracy of

method. The exponential weight is 0.94, the risk estimates.

which was the best performing weight in

this sample for the DTW. It has been ENDOGENOUS FINANCIAL

used because it allowed complete benefit INSTABILITY

of the doubt to the existing method. To proceed further one must identify

Figure 1 confirms something that is some theoretical framework that

widely recognised, namely that both resembles reality to a greater degree than

existing methods gave absolutely no the aforementioned assumptions of a

# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 369

Satchkov

relatively stable ‘equilibrium’ state. There unstable. The second theorem of the

are a number of economic approaches financial instability hypothesis is that over

that can be helpful in this regard. De periods of prolonged prosperity, the

Long et al. 3 show a model of market economy transits from financial relations

bubbles in which rational traders who that make for a stable system to financial

follow positive-feedback strategies are relations that make for an unstable

buying with rising prices and selling system.’5

with falling prices, thus producing

self-sustaining trends which ultimately Soros6 extensively discusses his view of

end in a crash. The situation of demand boom-bust sequences. His description,

rising with the price not infrequently although less rigorous than Minsky’s, gives

encountered in financial markets upsets a useful view into the mechanism of

traditional supply-demand relationships self-sustaining bubbles via the mechanism

and makes traditional equilibrium he calls ‘reflexivity’. Economy can deviate

approaches incapable of dealing with the very far from a theoretical equilibrium for

real world fluctuations. De Long et al.’s long periods of time, because many

model formalises a permanent theme in so-called ‘fundamentals’ under certain

the literature on self-reinforcing bubbles conditions can become highly intertwined

which goes back as far as Bagehot.4 with prices, which are supposed to reflect

Going further, Hyman Minsky5 them. The views of both Minsky and

identified the key features of the credit Soros explain how the risk gets built up to

cycle which tend to drive large an extremely high level owing to purely

boom-bust sequences. According to the endogenous market forces. The stage is

financial instability hypothesis (FIH), then set for a dramatic reversal. In an

fundamental relationships in the real exceptionally lucid explanation of systemic

economy and financial markets change risk, Danielsson and Shin7 write:

with the change in the behaviour of the

participants and particularly with the ‘One of the implications of a highly

change in the behaviour of the financial leveraged market going into reversal is that

intermediaries. For example, after a a moderate fall in asset value is highly

period of prosperity, an increase in the unlikely. Either the asset does not fall in

risk-taking activities takes place and value at all, or the value falls by a large

rising leverage builds, setting up the amount.’

potential for a violent downturn. Some

interruption will expose the Let us now summarise these insights in a

unsustainability of leverage levels leading framework that will help to develop a

to a credit contraction and a potential risk modelling approach, which can truly

collapse in the asset values. estimate risks, that is provide an early

Minsky summarised his insights in two warning of the instability potential.

theorems of the financial instability:

FRAMEWORK FOR THE

‘The first theorem of the financial INSTABILITY RISK APPROACH

instability hypothesis is that the economy (1) Financial market behaviour can be very

has financing regimes under which it is roughly divided into two states: a stable

stable and financing regimes in which it is state where a financial economy is an

370 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)

When swans are grey: VaR as an early warning signal

random deviations and an unstable one relies on the asymptotic properties of the

where it becomes a deviation- independent and identically distributed

amplifying system. (Of course, there are (i.i.d.) sample maxima and in that sense

many different specifications possible is similar to the central limit theorem for

but the aim is to capture only the most sums of i.i.d. variables. If one now makes

important aspects to build tractable an assumption that extreme observations

models.) gathered from different periods over a

(2) Currently used weighting schemes long time are independently and

allow the latest observed data to identically distributed, then one can

dominate the sample in any conditions. gather enough historical outliers to

This leads to a severe understatement of estimate the parameters of the GEVD

risks and an overstatement of any using the maximum likelihood methods.

diversification benefits during the low A good summary of the EVT approaches

volatility/low correlation stable phase can be found in Embrechts et al. 8 (1997).

and to an overstatement of risks in the EVT has been shown to be a powerful

bottom of the cycle. tool, see for example, Longin9 or Phoa,10

(3) An unstable state is characterised by the with a much better predictive power in

multiple feedback loops of liquidation the tail than attained by the current

resulting in a unique environment approaches. Still, there are some serious

which has no linear relation to the obstacles to its practical use in everyday

stable state. Therefore, data gathered in risk management and it is that use that

stable periods carry exceedingly little one is most concerned with here. EVT

value for the estimation of risks. presupposes unconditional distribution of

(4) As the risk taking behaviour in the the extreme values and is a purely

economy grows, a risk statistic should statistical framework with no linkages to

assign a greater weight to the data the economic conditions at large. Thus,

gathered during the unstable periods. even if it accurately represents the risk of

a tail event, it leaves the risk manager

with a risk estimate that is more or less

It is important to note that the first three constant through time. (This is because

assumptions, while contrary to the EVT methods use all available extreme

currently prevailing paradigm, are not observations in history to satisfy the

new, since they are implicitly asymptotic properties and fill the sample,

incorporated in the extreme value theory so that new extreme observations usually

(EVT) approach to financial risk do not significantly change the estimate.)

estimation. EVT is a statistical This constant estimate is bound to be

framework, which has been extensively quite high. The result is that, if this

used by financial risk researchers to estimate is acted on, it will produce a

overcome the deficiencies of the EW and permanent bracing for the crash, a state

DTW approaches and the resulting focus which was explicitly alluded to earlier, as

on stable periods. EVT relies on a neither feasible in a competitive financial

theorem, which postulates that extreme economy nor desirable for the economic

values from different distributions can be development. In other words, it may

modelled as coming from the generalised correctly estimate the tail, but it says

# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 371

Satchkov

nothing about the potential changes in are met in relation to the risk

its likelihood. This is why it is necessary (mis)pricing metrics.

to draw on the ideas outside of a purely In the interest of the simplicity of

statistical framework to estimate the presentation, one can take the most basic

instability potential of the economy. The and perhaps most widely used type of

author here argues that statistics should VaR, the parametric VaR, and start with

be strictly subordinate to the economic the EW and DTW methods of using the

reasoning in risk modelling and that past data for its estimation. One will then

heuristics should be used where they are introduce an instability estimator of

necessary. parametric VaR. The testing of the

instability estimator will show that, even

INSTABILITY ESTIMATOR OF with an obviously simplistic parametric

THE PARAMETRIC VAR VaR, it can do a good job of capturing

The conclusions in the above framework tail risks.

lead to the new paradigm for the

inclusion of the past data in the risk

estimation process. As the excess Construction of the instability

risk-taking persists, a financial economy estimator of parametric VaR

becomes increasingly vulnerable to all EW and DTW estimators of VaR have

types of shocks. This framework already been described above. This paper

motivates the following definition of a will now describe the instability estimator

new class of risk estimates: and run back tests comparing the three

of them. Since parametric VaR is being

Instability estimator of risk (IER) is used, the instability estimator of

calculated by assigning progressively (co)variance will take the following

greater weight to the observations from form:

the extreme portion of the sample when

c h i

two conditions are present: INST 1 X

s2j;k ¼ WEX r EX r EX

n t¼1 j;t k;t

time þ ð1 WEX Þ ðEW s2j;k Þ

(2) The trend of worsening risk ð4Þ

mispricing stops and shows signs

of reversal. where:

WEX — weight assigned to the extreme

Risk mispricing can potentially be observations (similarly to EVT methods,

measured by a variety of more or less in order to find enough of these extreme

easily observed metrics. In this class of observations one must widen the

metrics one can include available sample as much as possible. In

price-to-earnings ratios, junk credit this study, the available sample for

spreads, housing price-to-rent ratios, extreme observations used starts on 31st

sovereign spreads, financial sector December, 1930)

leverage and others. The extreme sample c — is the number of observations that

observations will carry more weight satisfy the criteria to be chosen as

when two conditions in the definition extreme data points

372 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)

When swans are grey: VaR as an early warning signal

r EX

j;t — selected extreme period return of the concept to be tested without delving

the asset j or k at time t into the issues of the generalisation of the

and the instability estimator of parametric IER concept to the multiple asset/

VaR for asset j: multiple factor model.

With the above considerations in mind,

VaR ¼ k ðINST s j;j Þ the weighting function can be introduced:

k — scaling based on the confidence 0 0 1

level of VaR. DCPE;i þDCJS;i

B B C !

In practice there are two key choices that B B þ2 DCDJS;i C

need to be made: B

BMAX B

B ;1C

C1; 0:3

@ @ 20 A

(1) How to separate the stable from

unstable periods?

ð5Þ

(2) What is the form and parameters of

the weighting function in the

where:

formula above, in other words, how

i — time at which the risk (mis)pricing

to measure the risk-taking activity

and its reversal?

metric is observed and VaR is estimated

Risk mispricing metrics:

The answer to the first question can be DCPE;i — reverse decile of one-year

fairly straightforward. Since one cares average PE in the historical sample of all

about the tail events that are not well such average PEs (where deciles are made

captured by the existing methods, one fractional through multiplying decimal

can label as ‘unstable’ all of the past percentage ranks by ten, ie a rank of one

observations that were outside the 2.33 (highest possible value) becomes a decile

deviation band (that would be equivalent rank (that is reverse decile) of ten

to violating 99 per cent parametric VaR), (highest possible contribution to weight))

where standard deviation is calculated DCJS;i — decile of one-year average junk

using the EW method using all of the spread

history available. Risk mispricing reversal metric:

The second problem is considerably DCDJS;i — reverse decile of 180-day

trickier. The goal is to test the IER change in the average one-year junk

concept on a broad market index, spreads (sources of data are Standard and

specifically the S&P 500, so one needs to Poors, Merrill Lynch, and Haver

choose only the most broadly applicable Analytics)

measures of risk pricing. For the

risk-pricing part of the definition a It is clear from this weighting function

trailing one-year average price to that the weight of extreme periods

earnings ratio of the S&P 500 and a should be highest when smoothed PE is

trailing one-year average credit junk high, smoothed junk spreads (JS) are low

spread will be used. For the metric of and 180-day change in smoothed junk

risk-pricing reversal part a 180-day spreads (DJS) is high (ie spreads are

percentage change in the average credit trending up after a period of risk

junk spread will be used. This will allow mispricing). The combined weight of PE

# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 373

Satchkov

equal to one half, while the weight of Figures 2 –5 summarise in graphical form

DJS, as representing the warning of the some of the key advantages of the IER

end of mispricing, is also equal to one method. In Figure 2 it is seen that, just as

half. All this follows the definition of the in 2008, both EW and DTW methods

IER above. The combined deciles are did not provide any early warning about

divided by 20 and one is subtracted from the Long Term Capital Management

the total. The highest possible value of (LTCM) crash. Instability VaR on the

the sum of deciles is 40, so the weight contrary showed sharply increased risk

of the extreme sample will vary from after the Asian currency crisis and kept

zero to one directly proportionally with the risk elevated leading up to August of

the increase in the sum of deciles of the 1998, just as LTCM loaded up on

original signals. The maximum function short-volatility trades they viewed as

ensures that when the sum of signals is exceptionally attractive, perhaps because

below 20, the weight is zero and not they were using the standard methods of

negative, while the minimum function VaR calculation.

caps the total weight of the extreme Figure 3 shows a similar story prior to

periods to 30 per cent of the sample to the dot-com bubble crash. Both EW and

avoid calculating VaR based on only a DTW methods showed low risk and

small number of observations in the tail. DTW even showed a significant decrease

(The results are not changed significantly in VaR at the worst possible moment

with small or even moderate changes in just a few weeks leading up to the

these settings, thus indicating robustness.) beginning of meltdown in April 2000.

It should be clear that formula (5) Instability VaR on the other hand

occupies in the IER paradigm the same showed a dramatic increase in risk in

place occupied by the exponential decay January 2000.

weighting in the presently accepted one, While early warning should be a

that is, its purpose is to indicate which critical objective for risk models, it is

periods carry more valuable information. important that financial firms put

The present paradigm assumes that recent themselves in a position to benefit from

periods are always more valuable, while the boom and not be permanently

the IER is based on the assumptions that braced for crisis. (Of course, the issue is

there are other factors that govern this being discussed from the perspective of

relative importance of data points. the individual user given the financial

Let us summarise what would be system that is in place now. The

expected from the instability estimator aggregate effects on the economy are a

based on the formulae (4) and (5). The different story and regulators would do

instability estimator is essentially a well to consider other uses for this

weighted average of the EW estimator model to possibly smooth out the

and a similar calculation, but based only risk-taking cycle.) Figure 4 shows that

on the extreme periods (the first term on this would indeed be the case with the

the right-hand side of formula (4)). The instability VaR approach. For the

weight between those two terms varies period from the beginning of 2002 to

with the signals for the risk-taking the end of 2006, the risk would

activities of the boom-bust cycle. largely be the same as under EW and

374 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)

When swans are grey: VaR as an early warning signal

DTW methods. The two exceptions author does not view these false alarms

are a few months at the end of 2004 as failures of the model; rather they

and the second half of 2005. The represent ‘tests of the bubbles’, as

# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 375

Satchkov

discussed by Soros.6 The only way to Basel VaR testing. The traffic light test,

distinguish a burst of the bubble from also called the binomial test, is based

a ‘test’ is ex post. on the idea that, with a large enough

Figure 5 repeats Figure 1, but with sample, an adequate VaR model should

the instability VaR added. Instability have the percentage of its violations

VaR clearly showed increased risk being close to 1 per cent for the 99

starting in July 2007 and did not per cent confidence VaR.

decrease despite numerous minor rallies It is obvious from Table 1 that both

and some ‘lull before the storm’. The EW and DTW methods show

performance of the EW and DTW in significant deficiencies in all periods.

this period was already discussed. Instability VaR, on the other hand,

shows good results for all periods, even

STATISTICAL TESTING the most challenging ones for a risk

The results of the testing are model, such as the one from the end of

summarised in Tables 1 and 2. Table 1 2006 to the end of 2008.

shows the percentage of time that the Finally, Figure 3 shows the statistical

actual return for the S&P 500 breaks test based on the likelihood ratio (LR)

through the 99 per cent VaR band. suggested by Kupiec.12 LR is given by

This test is based on Basel traffic light the following formula:

test11 but we will use a much bigger

sample that encompasses different

portions of the cycle to avoid the ð1 qÞnv qv

LR ¼ 2 LN ð6Þ

deficiency of the short sample in the ð1 rÞnv r v

376 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)

When swans are grey: VaR as an early warning signal

n — number of observations in the with one degree of freedom. Using the

sample chi-square tables, one can infer the lower

v — number of violations ie number of and upper bounds for the number of

times that 99 per cent VaR was breached violations that would need to be

q — desired violation rate observed in order not to reject the

r — empirical violation rate ie v/n. hypothesis that the 99 per cent VaR is

violated 1 per cent of the time (ie that it

The null hypothesis being tested here is:

is likely a 99 per cent VaR or something

H0 : r ¼ q close to it is being produced).

Per cent violations (Basel)

Period EW (%) DTW (%) Instability (%)

31st December, 2005 to 21st May, 2010 2.99 2.90 1.54

31st December, 2001 to 21st May, 2010 1.90 2.10 0.99

31st December, 1997 to 21st May, 2010 1.75 1.90 0.83

31st December, 1993 to 21st May, 2010 1.97 2.00 1.13

26th April, 1989 to 21st May, 2010 1.82 1.93 1.03

31st December, 2006 to 31st December, 2008 4.75 3.56 1.58

# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 377

Satchkov

Table 2: Actual number of violations along with 10 per cent (5 per cent on each side) confidence

range

Number violations (significance)

10% confidence

Period bound EW DTW Instability

31st December, 2005 to 21st May, 2010 From 6 to 18 33 32 17

31st December, 2001 to 21st May, 2010 From 12 to 30 40 44 21

31st December, 1997 to 21st May, 2010 From 22 to 42 55 60 26

31st December, 1993 to 21st May, 2010 From 30 to 54 82 83 47

26th April, 1989 to 21st May, 2010 From 40 to 68 97 103 55

31st December, 2006 to 31st December, 2008 From 2 to 9 24 18 8

instability estimator dominates the group. of VaR to be addressed without

It is also seen that EW and DTW abandoning the metric known for its

estimators are consistently rejected by a ease of use and communication. Further

wide margin. For example, for the whole research into instability risk measures

period from 26th April, 1989 to 21st could proceed in a number of directions.

May, 2010 actual S&P 500 returns violate The first direction would be to adapt the

the EW VaR 97 times and DTW VaR approach outlined above to a multi-asset

103 times. The implied 90 per cent class framework by refining the proxies

confidence range for the correct for the risk-taking activity across various

binomial distribution is between 40 and asset classes. This could take the form of

68 violations. Instability VaR gives 55, looking for a more nuanced and accurate

near the middle of the range. The index of various types of leverage

same situation holds for all other (including hidden leverage) and adding

subsamples. sector and asset class specific risk-pricing

metrics, eg sector-specific credit spreads

CONCLUSIONS or house price to rent for the real estate

The failure of the financial risk market. The second direction could be

estimation to give any warnings of the implementation of advanced

danger is widely known, especially after optimisation algorithms for the data

the 2008 crash. This paper suggests a weighting function. The choice was

modified calculation of the popular made not to do that here in order not to

value-at-risk (VaR) measure with a link clutter the presentation of a novel

to the pricing of risk in the financial measure with the additional complex

economy. Comparing the accuracy of algorithm which itself must be fine

this measure over the past 21 years of the tuned and evaluated, but it would

S&P 500 returns against the commonly present an interesting topic as a separate

used equal weighted (EW) and decay study to find if improvement on the

time weighted (DTW) estimates of presented relatively simple algorithm

parametric VaR shows that it can provide could be obtained. The third extension

significant improvement in the estimation of research would be to apply the

of market risk. Implementation of the concept of instability VaR to different

instability estimator of risk (IER) will distributions like the multivariate Student

378 Journal of Risk Management in Financial Institutions Vol. 3, 4 366–379 # Henry Stewart Publications 1752-8887 (2010)

When swans are grey: VaR as an early warning signal

pursuing all three directions. ‘Endogenous risk’ in ‘Modern

Risk Management: A History’,

References Introduced by Peter Field, Risk

1 Taleb, N. N. (2007) ‘The Black Swan: Books, London.

The Impact of the Highly Improbable’, 8 Embrechts, P., Kluppelberg, C. and

Random House, New York, NY. Mikosch, T. (1997) ‘Modelling Extremal

2 Holton, G. A. (2003) ‘Value-at-Risk: Events: For Insurance and Finance’,

Theory and Practice’, Academic Press, Springer, New York, NY.

Boston, MA. 9 Longin, F. M. (1996) ‘The asymptotic

3 De Long, B., Shleifer, A., Summers, L. distribution of extreme stock market

and Waldmann, R. (1990) ‘Positive returns’, Journal of Business, Vol. 69,

feedback investment strategies and No. 3, pp. 383– 408.

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The Journal of Finance, Vol. XLV, No. 2, risk using extreme value theory’, Journal

June, pp. 379 –395. of Portfolio Management, Spring, Vol. 25,

4 Bagehot, W. (1872) ‘Lombard Street: A No. 3, pp. 69– 73.

Description of the Money Market’, 11 Basel Committee on Banking

Scribner and Armstrong, New York, NY. Supervision (1996) ‘Supervisory

5 Minsky, H. P. (1992) ‘The Financial Framework for Use of Backtesting in

Instability Hypothesis’, working paper Conjunction with the Internal Models

74, May, Levy Economics Institute, Bard Approach to Market Risk Capital

College, Annandale-on-Hudson, New Requirements’, Bank for International

York. Settlements, Basel, January.

6 Soros, G. (1987) ‘The Alchemy of 12 Kupiec, P. H. (1995) ‘Techniques for

Finance: Reading the Mind of verifying the accuracy of risk

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New York, NY. Derivatives, Vol. 3, No. 2, Winter.

# Henry Stewart Publications 1752-8887 (2010) Vol. 3, 4 366– 379 Journal of Risk Management in Financial Institutions 379

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