Bubble Value at Risk: A Countercyclical Risk Management Approach, Revised Edition

Chapter 9

Practical Limitations of VaR

Chapter 7 discussed the theoretical flaws of value at risk (VaR). Here we consider the practical limitations when implementing and using a VaR system. It is a novice’s mistake to assume that all identifiable missing risks can be put back into the VaR model. There are practical blind spots that are beyond the ability of VaR to cover.

9.1 DEPEGS AND CHANGES TO THE RULES OF THE GAME

Like any measurement device, VaR is a function of its information input. To the extent that a market event does not produce timely data for input to the VaR system, it follows that the risk for that event can never be captured. This is the case for some types of events that are not registered in prices, even though they may be anticipated by a knowledgeable risk manager.

The classic examples are currency controls and depegs. During the Asian currency crisis from 1997 to 1998, the Malaysian ringgit was attacked by currency speculators due to contagion from a currency crisis that started in Thailand. The Thai central bank devalued the baht on July 2, 1997, after which the ringgit depreciated from 2.52 to a high of 4.77 against the dollar, a whopping 47% fall. To fend off currency speculators, the Malaysian central bank imposed capital control in September 1998—pegging the ringgit to the dollar at 3.8. After seven years, the central bank officially lifted the peg on July 21, 2005. The ringgit is still semicontrolled to this day.

Figure 9.1 shows this chronology of events ...