Pandora's Risk: Uncertainty at the Core of Finance by Kent Osband

Author:Kent Osband
Format: epub
Tags: Business and Economics/General
Publisher: Perseus Books, LLC
Published: 2011-08-29T04:00:00+00:00

“I feel sorry for the American cigarette companies,” said Prometheus. “They got in so much trouble over exaggerated claims for filters. They should have introduced a Cancer-at-Risk standard. It would explain the worst cancer the healthiest 95% of smokers would develop in two years.”

“That wouldn’t have saved them,” said Pandora. “The standards for peddling tobacco are much stricter than the standards for peddling financial carcinogens. In finance, let the sucker beware. Besides, you overlook the power of the name.”

“A rose by any other name would smell as sweet.…”

“That’s because a rose is directly material. Value is a perception.”

“Markets make value material, by trading money for real goods and services.”

“By that criterion VaR isn’t even value. It’s a threshold. Have financial institutions issue puts to cover the losses beyond their VaR. Now there would be value. But it could deviate a lot from the VaR.”

“If VaR is such rubbish, why not ban its use?” asked Prometheus. “Or make users post big health warnings, like ‘VaR is hazardous to your financial health.’ ”

Pandora smiled. “I like the health warning idea. But I fear it would get tucked into the long disclaimers that lawyers write to each other. Besides, every estimate of risk can be converted into a VaR measure given some auxiliary assumptions. There’s nothing wrong with that.”

“People think empirical VaR is better, because it doesn’t need conversion.”

“That’s another big misconception. The only thing empirical VaR is great at predicting is itself. Most days it doesn’t change at all.”

“I like Osband’s approach. Pick a measure of observed tail risk, set up a market contest to predict it, and use the market-clearing consensus as the predictor. But I’m not that impressed with the measures he uses. He would do much better looking at trading ranges.”

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