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On the White Board - June 2009
Jun 15, 2009
The last four years in the financial markets have offered extreme contrast, with 2005 and 2006 having an unusually low volatility, while 2007 and 2008 presented extreme crises (mortgage and credit crises, liquidity crunch, Lehman bankruptcy, etc.). As a risk provider, this period presents a unique opportunity to test our risk models in a very dynamic landscape. A large scale backtest exercise was conducted for this purpose, covering various instruments ranging from plain equities to CDS. The backtest technology has been considerably expanded in order to compute precise diagnostics of the possible deficiencies for the risk estimation associated with any position. As the historical and RM1994 risk methodologies present already known deficiencies (poor capture of the volatility dynamics, no fat tails), the RM2006 methodology is exclusively used for the backtest. A significant computational effort was needed in order to gather sufficient statistics for hundreds of positions.
Overall, the RM2006 risk methodology delivers good risk measures regardless of the instruments and market conditions. In particular, the common criticisms about market risk evaluation found in the popular press are invalid for this risk methodology. Yet, the occurrences of rare but large jumps lead to an overestimation of the volatility and risk in the following period. At a finer level, the results range from acceptable to excellent depending on the instrument, its detailed parameters and the risk horizons. For example, the risk for American options is very well captured, while CDS show deficiencies for risk horizon larger than one day.
While room for improvements certainly exist, the backtest results over a difficult period are good for most positions. Thanks to the accurate diagnostics provided by the backtest, the algorithms associated to each instrument can be improved when needed, until they can be validated. This ongoing effort is part of our commitment to deliver accurate market risk assessments using the latest innovations, over a wide range of financial instruments.