Value At Risk
By Philippe Jorion
Irwin Professional Publishing, Burr Ridge, Ill.

Reviewed by Satyajit Das

The concept of VAR has emerged as the centerpiece of the trend toward the measurement and management of market risk in financial transactions. The debate it has triggered has as much to do with the process of risk management and management of trading risk as with VAR.

Market risk has been present in the process of financial intermediation all along. Several factors have contributed to the increased focus on risk management: the deregulation of financial markets; the increase in risk profile of organizations, with increased emphasis on activities that require the deliberate assumption of risk; the volatility of markets and its impact on financial institutions; the pressure from capital market investors for returns related to the relative riskiness of their investments; and the regulatory pressures on a risk management framework.

The increase in trading activities of firms and the resulting volatility of income and overall increase in risk of the firm's activities has been much commented on of late. The reasons underlying the increase in trading include the fall in agency revenues as markets are deregulated; the increasing pressure from clients for execution based on the financial institution trading as principal rather than agent; and the perceived competitive advantage enjoyed by financial institutions in trading, including infrastructure, information, transaction costs and so on.

The assumption of risk is often presented as a relatively new phenomenon. In reality, the nature of risk-taking has changed. Traditional risk-taking was confined to balance-sheet-oriented interest rate risk created by deliberate maturity mismatches. Supplementary risk-taking may have been present in areas such as currency or securities trading.

Modern risk-taking, however, is more diverse in nature. It encompasses traditional forms of risk-taking and increased trading in other asset classes. This increased trading focus is driven by both client demands in terms of market-making, and proprietary or own-account trading, in search of return. This change reflects in no small part the increasing diversity of the activities undertaken by financial institutions, including activities in all asset classes (debt, currency, equity and commodities) and in businesses ranging from balance-sheet-driven activities (such as lending), off-balance-sheet activities (such as underwriting and securities distribution and risk management instruments), to pure fee-based activities (such as investment management, custody services and cash-management services).

Against this background, there has been a gradual but inevitable shift away from the paradigm of asset-liability management ("ALM"), with its balance-sheet orientation, to VAR approaches as the preferred means for measuring market risk.

Philippe Jorion, a well-credentialed academic, provides a cohesive and satisfactory explanation of the mechanics of VAR. The book is divided into four sections-"Motivation," essentially background material covering the need for risk management and the salacious topic of derivatives disasters; "Building Blocks," covering the statistical and financial concepts underlying risk measurement using VAR; "VAR Systems," which provides a comparative analysis of the different approaches to VAR-analytic, historical or simulation; and "Risk Management Systems," which provides some coverage of the implementation issues.

The book's strength is its solid coverage of the mechanical aspects of the sheer mathematics of VAR. The material is comprehensive and the treatment generally readable and accessible for the nontechnical reader. For the more mathematically oriented reader, the JP Morgan RiskMetrics technical manual may offer more challenging coverage of some of the more technical aspects of VAR.

Value At Risk does a good job of comparing the different types of VAR, although the author appears loath to nominate one methodology over another ("the best lesson...is to teach VAR measures with different methodologies and then analyze the sources of differences"). I favor historical VAR using a 250 to 500 day sample period supplemented by stress testing using Monte Carlo simulations. The chapter on credit risk, with discussion of the possibility of extending VAR to covering credit risk as well as market risk, is a good stroke as well.

I would have liked to see (though it may be a matter of personal preference) additional material on risk decomposition-the process of breaking down complex securities into essential risk factors; the impact of liquidity risk in calculating VAR, both in the sense of trading liquidity and cash requirements of trading including the capacity to hedge portfolios in stressful markets; and the systems and information technology issues in risk management.

Value At Risk is more telling in topics not dealt with than the material covered (this is not a criticism of the book or the author but of the state of debate on risk management). Some of the more important issues in risk management currently include the use of risk information (including risk reporting and its use in risk management) and the organization and role of the risk management function. An additional topic of great importance is the adaptation of VAR to the management of financial risk in nondealer organizations.

Too much of the current debate on risk management has focused on understanding the mathematics of risk and VAR. I sense that the real requirements of risk management lie with understanding and using risk information, an area that is somewhat less focused upon. Philippe Jorion's VAR provides a sound introduction to the mathematics and mechanics of VAR. As for risk management or controlling market risk, that's a broader issue.

Perhaps the ultimate touchstone of VAR is determining whether using it would have prevented any of the notable derivatives disasters. I think VAR may have helped, but without broader organizational efforts in risk management VAR on its own would not have prevented these disasters.

Dynamic Hedging
By Nassim Taleb
John Wiley & Sons Inc., New York

Reviewed by David F. DeRosa

Nassim Taleb's Dynamic Hedging is one of the best derivatives books to come along in years. Yet it is destined to be controversial within the practitioner community, because it is in small part an attack on the popular Value-at-Risk methodology. Taleb pulls no punches: "Don't even dream of applying it to derivatives," he writes. This should come as no surprise to readers of this magazine (see "The World According to Nassim Taleb, December/January). Taleb has clearly set himself up as the iconoclast of the risk management industry. It is no exaggeration to say that the American Medical Association probably has higher professional regard for osteopaths than Taleb has for VAR apostles.

The VAR question aside (and it is really only a subplot), the main topic of this remarkable book is the management of institutional option portfolios In today's marketplace, dealers take the other side of their customers' trades The accumulated position is referred to as the dealer's "central book" or "delta book." The prototypical "book runner"( Taleb's term) tries to stay flat on market direction by adjusting the hedged position in response to market moves-hence the term dynamic hedging. This leaves the trader with second-order risk position in volatility (vega), time decay (theta) and interest rates (rho), as well as exposure to higher-order derivatives. If the hedging goes well, the trader can capture a portion of the option bid-ask spread. This is big business. Some institutions run books with tens of thousands of options positions, aided by the obvious economy of scale in hedging that comes from having long and short positions in both puts and calls. The practice became substantially more complex-and quite a bit more lucrative-with the introduction of exotic options. This is where Taleb's book comes into its own. No other book has such a focus on taking option theory to the practical world of the book-runner's trading desk. Here it can be said that Taleb is generous in sharing proprietary trading secrets.

Something else should be said about this book. It is genuinely funny in places. Interspersed between all the calculus, trader jargon and risk management dictums are real-world anecdotes. (My favorite is "The Difficult Boss.") Then there is the one-line stopper from a Taleb-style trader on why a well-known market neutral hedge fund had abruptly melted down to zero: "That guy didn't get the second derivative right." Funny stuff about people who work in rooms with raised floors in front of batteries of screens and worry about Dgammadvol, delta bleed and shadow gamma.