A word of caution
The application of modern portfolio theory was very well received by banks, in part because it meets intuition that part of the risk disappears in a diversified portfolio, and also because it often results in a smaller measure of risk. In the negotiation on capital regulation for trading risk mentioned in Stage 6, international banks lobbied very hard, and succeeded in being allowed to incorporate the benefits of diversification in the measure of value-at-risk (VAR), the potential change of value of the trading portfolio.
But common sense reminds us that the end result, the estimation of total risk, is only as good as the quality of data input introduced in the formula. In particular, if correlations change, the measure of ...
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