We have long been adamant that risk models based on Value at Risk (VaR) or other backward-looking statistical models are close to useless. The reason is that the underlying correlations between financial variables are inherently unstable, and that this instability is most pronounced in periods of strong market movements.
In a remarkable piece, Jim Caron, Morgan Stanley's Head of International Bond Strategy admits to have found out that something is wrong. In a recent piece, he admits to having been wrong on interest rates and bond yields. It may well be so, but the more interesting is his observation of recent market movements.
"April and May were difficult months for us and others, judging by fund data on market performance. We did not properly discount the risks associated with peripheral Europe. As a result, we had a larger risk exposure than we should have. We measure the return potential for our positions on a per-unit-of-risk basis, similar to a Sharpe Ratio. That unit of risk turned out to be much higher than we anticipated. This will force us, and many others, to right-size our risks."
In other words: the models used to discount risk have understated the risk. Caron is optimistic that it is possible to "right-size". It counts in his favour that he actually tries to find a way out of the problem. He suggests the following
Liquidation of risk exposure: Portfolio positions turned out to be much more correlated than we had initially anticipated. Traders seek to reduce correlation by liquidating many positions, leaving behind perhaps only a few core positions. We saw these liquidations in May and early June
Sit, wait and re-assess: Traders will now have to evaluate the new risk relationships. Since there is great uncertainty, traders might start by making small and short-term tactical bets to get a feel for the risks. Again, only a few core positions may still be left on.
Right-size risk: As the new market environment becomes somewhat better understood – albeit still marked by great uncertainty and higher realized volatility – traders could now start to make an assessment on the proper risk they should have relative to the increased level of expected volatility of returns. For example, if the market is twice as volatile today as it was before, then one should run positions with half the size of risk.
For better or for worse – the introduction of a new tail risk: Given the losses taken and positions liquidated in the past few months, the new tail risk is for risky assets to reverse sharply higher and for yields to rise. This could cause traders to chase performance, so as not to be left behind relative to their peers. Similarly, if markets turn against them, then they will be quick to exit. This introduces two-way risk: traders may start to react equally to both good and bad news. Previously, the tail risk traders were mostly focused on a worsening of risky assets. Now they have to be concerned about both tails, for better or for worse, which will add to market volatility.
It all sounds very reasonable. But it sidesteps one important issue: the complete collapse of predictive models when multiple sigma events like the May Flash Crash and the accelerating sovereign collapse of the past several months occur.
Carons observation that "Portfolio positions turned out to be much more correlated than we had initially anticipated" hammers the point home - markets are not inherently stable. But the situation is more serious than Caron thinks: There are no models that can model the behaviour of the financial markets when disaster strikes. The solution is to introduce much simpler and much more pragmatic ways of dealing with risk, once it appears. Risk cannot be dealt with by a machine, however clever. This has been known for ages outside of the financial markets. The financial markets need to reconnect with the real world.