Assumptions Embedded in Risk Analysis
The picture below from Dour VanDemeter’s blog gives an interesting take on the embedded assumptions in various approaches to risk analysis and risk treatment.
But what I take from this is a realization that many firms have activity in one or two or three of those boxes, but the only box that does not assume away a major part of reality is generally empty.
In reality, most financial firms do experience market, credit and liability risks all at the same time and most firms do expect to be continuing to receive future cashflows both from past activities and from future activities.
But most firms have chosen to measure and manage their risk by assuming that one or two or even three of those things are not a concern. By selectively putting on blinders to major aspects of their risks – first blinding their right eye, then their left, then by not looking up and finally not looking down.
Some of these processes were designed that way in earlier times when computational power would not have allowed anything more. For many firms their affairs are so very complicated and their future is so uncertain that it is simply impractical to incorporate everything into one all encompassing risk assessment and treatment framework.
At least that is the story that folks are most likely to use.
But the fact that their activity is too complicated for them to model does not seem to send them any flashing red signal that it is possible that they really do not understand their risk.
So look at Doug’s picture and see which are the embedded assumptions in each calculation – the ones I am thinking of are the labels on the OTHER rows and columns.
For Credit VaR – the embedded assumption is that there is no Market Risk and that there is no new assets or liabilities (business is in sell-off mode)
For Interest risk VaR – the embedded assumption is that there is no credit risk nor new assets or liabilities (business is in sell-off mode)
For ALM – the embedded assumption is that there is no credit risk and business is in run-off mode.
Those are the real embedded assumptions. We should own up to them.
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