Lately, economists talk of three phases of the economy, boom, bust and “normal”. These could all be seen as risk regimes. And that these regimes exist for many different risks.
There is actually a fourth regime and for many financial markets we are in that regime now. I would call that regime “Uncertain”. In July, Bernanke said that the outlook for the economy was “unusually uncertain”.
So these regimes would be:
- Boom – high drift, low vol
- Bust – negative drift, low vol
- Normal – moderate drift, moderate vol
- Uncertain – unknown drift and unknown vol (both with a high degree of variability)
So managing risk effectively requires that you must know the current risk regime.
There is no generic ERM that works in all risk regimes. And there is no risk model that is valid in all risk regimes.
Risk Management is done NOW to impact on your current risk positions and to manage your next period potential losses.
So think about four risk models, not about how to calibrate one model to incorporate experience from all four regimes. The one model will ALWAYS be fairly wrong, at least with four different models, you have a chance to be approximately right some of the time.
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