Red-Blooded Risk: The Secret History of Wall Street

Looking Backward

This brings up the issue of backward-looking risk management. This has become a common charge against risk managers. The idea is that in periods of low market volatility, such as from 2004 to early 2006, you issue low estimates of risk. The result is that when market volatility goes up, the firm is holding positions scaled assuming a lower level of risk. The positions are too big and it's difficult to reduce them during a market crisis. Ironically, the conventional solution is supposed to be even more backward looking, to consider the risk of your positions in scenarios from the more distant past.

Both the problem and the solution are more complicated than that. The reason risk estimates were low in 2006 was not just that current market volatility was low. All sorts of other measures of risk were low as well. For example, one forward-looking measure of risk is how much traders charge to insure against future losses in the stock market. The Chicago Board Options Exchange Volatility Index (a market index called the VIX, sometimes referred to as the “fear indicator”) can be used for this. Another important indicator is whether asset prices are moving with some independence, as they normally do in calm times, or herding together, as they often do before and during a storm. Any unusual divergences are signs that risk may be picking up. Sharp changes in asset prices without an obvious underlying cause or erratic trading volumes can be clues of an approaching tsunami. ...