Risk Mismanagement

In risk evaluation you can use numbers to measure risk such as beta and Value at risk, but you can also use patterns from past events. Trends in markets occur, and sometimes trends in disasters occur. You can use the trends from the past to predict future crisis. Value at risk is a common measurement of risk that puts a dollar amount on the level of risk, how much capital a company should keep on hand to cover their risks. These tools and measurements are not as accurate when used alone, as my previous blogs have mentioned. The value at risk calculation can be combined with analyzing past trends to predict risk more accurately. The crisis caused confusion about risk management and whether it is useful or wrong. Risk management worked in the case of Goldman Sachs, so what is the problem then with risk management? It is in the uses of risk management and not being aware of the holes. If you are not looking for risks or disasters you won't see them when they are coming, and therefore, will not be prepared. As in my previous blogs, the value at risk calculation assumes a normal distribution. People take the calculation as is and ignore possible fat tails and outliers far away from the mean that cause higher risks. People use only the value at risk number, but do not realize it is short term and could change easily every day. Value at risk also does not take into account put options that could put a company at large risk if prices fall below the agreed price.

This reason is why people need to understand that problems can happen and you should be prepared. Crisis make people aware that bad things can happen. Using past events make people realize it could happen. Models are not the only tools that should be used to calculate risk because some risk cannot be hedged. There are diversifiable risks and non-diversifiable risks that can happen outside of a normal distribution. Risk management and VaR calculations help the firm be prepared. There is margin for error, but at least the firm has their eyes open. The VaR calculations 2 years ago stated things were getting bad, but no one used the warnings to prepare for the current crisis.

http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?_r=2&emc=eta1&pagewanted