6.1 Risk Measurement Limitations

Like any set of techniques or tools, risk measurement has definite limitations. This is not a problem; it is just the way the world is. A hammer is a useful tool, but it has limitations. It is good for pounding in a nail but not good for sawing a plank. Appreciating risk measurement limitations helps us understand when and where quantitative techniques are (and are not) useful. Failure to understand the limitations of risk measurement techniques, however, is a problem. Misusing the techniques in the face of limitations leads to mistakes, misunderstandings, and errors.

Models for Measuring Risk Will Not Include All Positions and All Risks

The models used to measure VaR, volatility, or whatever else will never include all positions and all risks. Positions may be missed for a variety of reasons. Perhaps some legacy computer system does not feed the main risk system, or some new system is not yet integrated. A new product may not yet be modeled, or someone may simply neglect to book a trade in a timely manner. A good and robust risk system will have processes and procedures for checking that all positions are captured and reporting those that are not. Nonetheless, there is always some possibility that positions are missed.

Likewise, the risk of positions that are included may not be properly represented. A complex derivative security may not be modeled correctly. Some product may have an unexpected sensitivity that is not captured by the risk system. ...

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