Saturday, January 3, 2009

Value at Risk

On Wall Street, what happens in the tails doesn't stay in the tails.

Joe Nocera at the New York Times today writes a fantastic article on Value at Risk, Nassim Taleb and what went wrong with Wall Street's ability to measure the risk it was taking, either intentionally or unintentionally.

"Yet even faulty historical data isn’t Taleb’s primary concern. What he cares about, with standard VaR, is not the number that falls within the 99 percent probability. He cares about what happens in the other 1 percent, at the extreme edge of the curve. The fact that you are not likely to lose more than a certain amount 99 percent of the time tells you absolutely nothing about what could happen the other 1 percent of the time. You could lose $51 million instead of $50 million — no big deal. That happens two or three times a year, and no one blinks an eye. You could also lose billions and go out of business."

You should read it.

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