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Bubble Value at Risk: Extremistan and Procyclicality Hardcover – January 3, 2011

4.8 out of 5 stars 4 customer reviews

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Hardcover, January 3, 2011
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Editorial Reviews

From the Author

From the preface:

This is a story of the illusion of risk measurement. Financial risk management is in a state of confusion. The 2008 credit crisis has wreaked havoc on the Basel pillars of supervision by highlighting all the cracks in the current regulatory framework that had allowed the credit crisis to fester, and ultimately leading to the greatest crisis since the Great Depression. Policy responses were swift--UK's Financial Services Authority (FSA) published the Turner Review which calls for a revamp of many aspects of banking regulation, the Bank of International Settlements (BIS) speedily passed a Revision to its Basel II, while the Obama administration calls for a reregulation of the financial industry reversing the Greenspan legacy of deregulation. The value-at-risk risk measure, VaR, a central ideology for risk management, was found to be wholly inadequate during the crisis. Critically, this "riskometer" is used as the basis for regulatory capital--the safety buffer money set aside by banks to protect against financial calamities. The foundation of risk measurement is now questionable.

The first half of this book develops the VaR riskometer with emphasis on its traditionally-known weaknesses, and talks about current advances in risk research. The underlying theme throughout the book is that VaR is a faulty device during turbulent times and by its mathematical sophistication misled risk controllers into an illusion of safety. The author traces the fundamental flaw of VaR to its statistical assumptions--of normality, i.i.d. and stationarity--the "gang of three". These primitive assumptions are very pervasive in the frequentist statistics philosophy where probability is viewed as an objective notion and can be measured by sampling. A different school of thought, the Bayesians, argues for subjective probability and has developed an entire mathematical framework to incorporate the observer's opinion into the measurement (but this is a subject matter for another publication). We argue that the frequentist's strict mathematical sense often acts as a blinder that restricts the way we view and model the real world. In particular, two "newly" uncovered market phenomena-- extremistan and procyclicality--cannot be engaged using the frequentist mindset. There were already a few other well-known "market anomalies" that tripped the VaR riskometer during the 2008 crisis. All these will be detailed later.

In Part IV of the book, the author proposes a new risk metric called bubble VaR (buVaR) which does not invoke any of the said assumptions. BuVaR is not really a precise measurement of risk; in fact it presumes that extreme loss events are unknowable (extremistan) and moves on to the more pressing problem--how do we build an effective buffer for regulatory capital that is countercyclical, and that safeguards against extreme events. This book is an appeal (as is this preface) to the reader to consider a new paradigm of viewing risk--that one need not measure risk (with precision) to protect against it. By being obsessively focused on measuring risk, the risk controller may be fooled by the many pitfalls of statistics and randomness. This could lead to a false sense of security and control over events which are highly unpredictable. It is ultimately a call for good judgment and pragmatism. This book is intended to reach out to the top management of banks (CEOs and CROs), to regulators, to policy makers and to risk practitioners--not all of whom may be as quantitatively inclined as the specialized risk professional. But they are the very influencers of the coming financial reregulation drama. We are living in epic times and ideas help shape the world for the better (or for worst). It is hoped that the ideas in this book can open up new and constructive research into countercyclical measures of risk.

With this target audience in mind, this book is written in plain English with as few Greek letters as possible, the focus is on concepts (and illustrations) rather than mathematics. Because it is narrowly focused on the topic, it can be self-contained. No prior knowledge of risk management is required; pre-university level algebra and some basic financial product knowledge are assumed. A word on the use of Excel: All the spreadsheets used in this book can be downloaded from the companion website:   bubble-value-at-risk.com.

From the Inside Flap

Most risk management books introduce Value at Risk (VaR) by focusing on what it can do and its statistical measurements. The credit crisis in 2008 was a tidal wave that debunked this well-established risk metric. In this book, the author introduces VaR by looking at its failures instead and explores possible alternatives for effective crisis risk management, including a new method of measuring risks called Bubble Value at Risk that is countercyclical and can potentially buffer against market crashes.

The frequentist statistics-based VaR is predictive during normal circumstances but often fails patently during rare crisis episodes. In reality, crisis periods span only a tiny portion of financial market history. By relying on VaR for crisis risk management, we are using a tried-and-tested tool for the wrong occasion — mistaking the trees for the forest. The book argues that we need to unlearn our existing "science" of risk measurement and discover more robust ways of managing risk and calculating risk capital.

The book illustrates virtually every key concept or formula with a practical, numerical example, many of which are contained in interactive Excel spreadsheets.

--This text refers to an alternate Hardcover edition.
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Product Details

  • Hardcover: 350 pages
  • Publisher: IMMANUEL CONSULTING PTE. LTD. (January 3, 2011)
  • Language: English
  • ISBN-10: 9810872763
  • ISBN-13: 978-9810872762
  • Product Dimensions: 6.1 x 0.8 x 9.2 inches
  • Shipping Weight: 1.2 pounds
  • Average Customer Review: 4.8 out of 5 stars  See all reviews (4 customer reviews)
  • Amazon Best Sellers Rank: #6,881,877 in Books (See Top 100 in Books)

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Top Customer Reviews

Format: Hardcover
"If you are distressed by anything external, the pain is not due to the thing itself but to your own estimate of it; and this you have the power to revoke at any moment".
Marcus Aurelius has summed it up appropriately in his "Meditations on Stoic Philosophy" and Bubble Value-at-Risk exercises this power not to revoke but to refine.

Value-at-risk has a rather dubious track record as a basis for calculation of risk capital. Exaggerated reliance on this tool by the regulatory authorities only exacerbated the fall out of bad judgments based on this "intuitive" estimate of risks. Can "Stressed Value-at-risk" generate sufficient prudence to save for the proverbial rainy day? Are the regulators geared up to face "adaptive challenges" or have they become prisoners of their own system?
Max Wong's book is an ideal expression of his self-reflection on the issue of capital buffers (or rather the lack of them!). The concept of BuVaR (Bubble Value-at-Risk) germinates from his ideas of an "ideal capital regime" based on his own way of processing business cycles as a risk management practitioner. Distorting or even drowning the VaR noises and re-viewing patterns in the risk environment led him to a simple but key question "isn't the risk of a crash higher at the peak than at the trough?" And, what is more, crashes always occur one way, downwards!
The BuVaR attempts to do away with the major shortcomings of VaR - Too Little, Too Late. BuVaR is sure to appeal to regulators as it is conservative and penalizes position taking in the direction of a bubble (in the case of Market BuVaR) and its extension into the world of credit (Credit BuVaR) helps aggregate default risk with credit VaR to sound the alarm of credit deterioration way ahead of time.
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Format: Hardcover
Having worked in the insurance industry for a number of years, I have had strong doubts about using standard VAR metrics to manage regulatory capital. In particular, it seemed strange to me that VAR did not seem to take account of market cycles, was highly reliant on historical data and only recognised regime shifts after the fact. The result of this would seem to be a highly procyclical capital regime, forcing regulated entities into large sell offs at the bottom of the market and resulting in the type of risk aversion and liquidity trap we are all too familar with in recent years.

This book works on two levels. Firstly, it provides an easy to understand critique of the mathematical assumptions underpinning VAR, going beyond the well rehearsed issues with assumptions of normal distribution and fat tails. Secondly, even more importantly, it provides suggestions for the way forward both for calculating capital at the entity level and managing systemic risk at the global level. While a basic understanding of statistics would be useful, a lot of the most important ideas are explained in a way that you do not need any mathematical background to understand.

I highly recommend this book for anyone with an interest in the calculation of regulatory capital and management of systemic risk - both extremely topical in the current business environment.
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Format: Hardcover
Despite being in essence a critique on VaR and a recommendation for a more "macroprudential" risk measure (the author's "Bubble VaR"), this is actually an excellent and accessible description of the standard VaR measure itself. It's worth getting for that reason alone, Mr Wong's writing style is so clear and lucid that he makes a very arcane and technical subject (almost) an easy read.

He is right to point out the obvious limitations of VaR, although I often think the complaints of VaR stem as much from a misunderstanding of what it was always supposed to be, compared to what it obviously couldnt do but was touted as being good for, if you know what I mean. The author recommends the Bubble VaR technique as a means to avoid the limitations of VaR and move towards a more accurate risk exposure estmation over the cycle. In that regard, this is definitely worth reading, especially by all bank CROs.

A great effort with Book No. 1. I look forward to Mr Wong's next works.
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Format: Hardcover Verified Purchase
a new way of measuring VaR, a new methodology, more realistic, more adapted, more global, an new frontier in Risk Managment!
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