When swans are grey: VaR as an early warning signal

Abstract

The market events of 2008 will be remembered as much for their extreme volatility as for a widespread failure of the risk management, which contributed to the near collapse of many firms thought to be among the leaders in that field. This paper identifies a key deficiency in the way that the historical data are currently utilised in the estimation of risk. This deficiency stems from the conception of the marketplace as an equilibrium-seeking and continuous system and it led to the financial firms’ unpreparedness for sudden market reversals. A different framework for risk estimation is proposed based on linking the risk modelling with the existing literature on financial instability. One possible application of the proposed method to the estimation of value-at-risk (VaR) is demonstrated, and empirical tests comparing it with the traditional methods are performed using S&P 500’s history from 1989 to 2010. The new measure, called the instability VaR, is shown to dominate all traditional methods of calculation.