Risk Models and the Credit Crisis

Posted by Tim Hope on 10/2/08 10:08 am

Pundits and politicians are spending much time and energy looking for scapegoats and policy solutions to the current credit crisis.  Little has been said, however, as to one of the possible root causes of much of the credit market turmoil – value at risk modeling.  Value at risk modeling is a financial technique designed by Wall Street financial engineers with the goal of capturing the degree of potential risk (and thus total dollar exposure) in a given investment.  At the heart of such risk model assumptions is that asset risk and returns are normally distributed, in other words, they have a familiar “bell curve” shape.  Under such an assumption, extreme outlying events can be shown to be so unlikely that they could be discounted as being nearly impossible (the “once in a century” term comes to mind).  However, remove the normal bell curve assumption and suddenly extreme events can occur far more frequently.  Thus, investment losses can be far greater and more frequent that expected – much more so that the model would otherwise predict.  The continued over reliance on the accuracy of value at risk models may be a continued thorn in the side of the capital markets. Click here for an easy to understand article on the subject.

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