Value at Risk - History of VaR

History of VaR

The problem of risk measurement is an old one in statistics, economics and finance. Financial risk management has been a concern of regulators and financial executives for a long time as well. Retrospective analysis has found some VaR-like concepts in this history. But VaR did not emerge as a distinct concept until the late 1980s. The triggering event was the stock market crash of 1987. This was the first major financial crisis in which a lot of academically-trained quants were in high enough positions to worry about firm-wide survival.

The crash was so unlikely given standard statistical models, that it called the entire basis of quant finance into question. A reconsideration of history led some quants to decide there were recurring crises, about one or two per decade, that overwhelmed the statistical assumptions embedded in models used for trading, investment management and derivative pricing. These affected many markets at once, including ones that were usually not correlated, and seldom had discernible economic cause or warning (although after-the-fact explanations were plentiful). Much later, they were named "Black Swans" by Nassim Taleb and the concept extended far beyond finance.

If these events were included in quantitative analysis they dominated results and led to strategies that did not work day to day. If these events were excluded, the profits made in between "Black Swans" could be much smaller than the losses suffered in the crisis. Institutions could fail as a result.

VaR was developed as a systematic way to segregate extreme events, which are studied qualitatively over long-term history and broad market events, from everyday price movements, which are studied quantitatively using short-term data in specific markets. It was hoped that "Black Swans" would be preceded by increases in estimated VaR or increased frequency of VaR breaks, in at least some markets. The extent to which this has proven to be true is controversial.

Abnormal markets and trading were excluded from the VaR estimate in order to make it observable. It is not always possible to define loss if, for example, markets are closed as after 9/11, or severely illiquid, as happened several times in 2008. Losses can also be hard to define if the risk-bearing institution fails or breaks up. A measure that depends on traders taking certain actions, and avoiding other actions, can lead to self reference.

This is risk management VaR. It was well established in quantitative trading groups at several financial institutions, notably Bankers Trust, before 1990, although neither the name nor the definition had been standardized. There was no effort to aggregate VaRs across trading desks.

The financial events of the early 1990s found many firms in trouble because the same underlying bet had been made at many places in the firm, in non-obvious ways. Since many trading desks already computed risk management VaR, and it was the only common risk measure that could be both defined for all businesses and aggregated without strong assumptions, it was the natural choice for reporting firmwide risk. J. P. Morgan CEO Dennis Weatherstone famously called for a “4:15 report” that combined all firm risk on one page, available within 15 minutes of the market close.

Risk measurement VaR was developed for this purpose. Development was most extensive at J. P. Morgan, which published the methodology and gave free access to estimates of the necessary underlying parameters in 1994. This was the first time VaR had been exposed beyond a relatively small group of quants. Two years later, the methodology was spun off into an independent for-profit business now part of RiskMetrics Group.

In 1997, the U.S. Securities and Exchange Commission ruled that public corporations must disclose quantitative information about their derivatives activity. Major banks and dealers chose to implement the rule by including VaR information in the notes to their financial statements.

Worldwide adoption of the Basel II Accord, beginning in 1999 and nearing completion today, gave further impetus to the use of VaR. VaR is the preferred measure of market risk, and concepts similar to VaR are used in other parts of the accord.