In risk management, as in many other business disciplines, you manage what you measure. As discussed in Chapter 3, risk measurement is one of three components of the basic risk management process—the other two being risk awareness and risk control.
Risk measurement analytics are therefore an invaluable part of the risk management process. Trying to manage risk without appropriate analytical tools is like trying to fly a plane without instrumentation—while the weather is good, everything is fine and the organization may not experience substantial losses. But in bad weather, the organization can be put in grave danger without any sense of where it lies.
Increased awareness of the challenges of ERM has therefore led to increased development of advanced analytical and reporting tools. Since the early 1990s, volatility-based models such as Value-at-Risk (VaR) have been applied to the measurement and management of all types of market risk within an organization. Value-at-risk can be defined as the maximum potential loss that a position or portfolio will experience within a specific confidence level over a specific period of time. In market risk management, the use of VaR models has become standard practice for estimating potential loss and establishing risk limits.
Similar models, along with models of corporate default, have more recently been applied to credit risk management; some companies have even begun experimenting with the application of these techniques ...