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Alternative Market Briefing

Simplistic Risk Models Miss Tail Risk
Monday, January 30, 2012

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David Merrill Bailey McCann, Opalesque New York:

Risk and risk management are becoming increasingly more complex and important for both managers and investors alike. Once, shuffled to the back of the stack of investor reports, risk management is emerging as an area of investor interest, as market volatility leaves investors seeking stable returns. However, overreliance on simplistic modeling can lead to misreading market conditions according to David Merrill, CEO of FinAnalytica, a New York-based risk solutions provider.

"Models aren’t perfect, but they should be able to give you relevant results," Merrill explains. Often, managers rely on simplistic models that they know well and are comfortable with, but this can often leave them vulnerable to fat tails, volatility clustering, skewness and correlation asymmetry. Standard measures like value-at-risk (VaR) and their traditional modifications often fail to account for fat tails or market correlations, which can increase overall portfolio risk or lead to losses if missed.

According to Merrill, "the lack of evolution from commercial vendors is holding back the industry," in this area. Commercial grade solutions for models that take into account fat tails, correlation or volatility are often hard to find. This creates a disparity where managers who are more quantitatively focused build models to track fat tails on their own, and those that aren’t comfortable with it don’t.

This unevenness may be better ......................

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