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The Gaussian Copula and VAR

Posted in Finance, Risk Management by Pankaj Gudimella on March 3, 2009

Risk management is very important for any firm, especially in the financial sector. Risk and return are inherently related to each other, there is a tradeoff associated with them. There certainly are times where more risk means more return and there are also times where more risk means no return. Many individuals and firms have come up with various models/formula to assess this risk-return phenomena.

The most successful formula of them all has been the VAR – Value at Risk. Almost all the firms use it today and have used it for the last couple of decades to understand not only a portfolio’s risk but the overall firm’s risk. But there is one serious detractor to VAR and that is Nassim Taleb. He says “VAR is like an airbag that works all the time except when you have a car accident”. Here is a good article from NYTimes on the heavy reliance of the Wall Street on VAR and how it affected their Bottomline.

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Another formula that Wall Street fell in love was what is called “The Gaussian Coupla” devised by David Li. You can read more here about how this formula was used and how it destroyed many firms on the street.

I think the lesson learnt from these stories is to avoid heavy reliance on one single metric/formula/model to run a business. The reason being none of them would be able to account for the Black Swan. And it is also true that the metrics created with the Black Swan scenarios in perspective wouldnt take into consideration the regular scenarios. There is no hard and fast rule here. Use the metrics/formulas/models with caution, understand the limitations that come with them, understand the upside and the downside, and hey use your gut feel and intuition!

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