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Risk Experts Speak Out: Where the CCRO Fell Short

A surprisingly timid effort for an industry on the brink.

Fortnightly Magazine - January 15 2003

for what should constitute minimum safe levels of risk-capital-to-VaR . 9

[Editor’s Note: The value-at-risk of a portfolio is the worst loss expected to be suffered over a given period of time with a given probability. The time period is known as the holding period and the probability is known as the confidence interval. Value-at-risk is not an estimate of the worst possible loss, but the largest likely loss.] 

Furthermore, the CCRO does not address the reliability and accuracy of model inputs. The best VaR models and strictly enforced VaR limits are rendered useless if there is not a framework to guarantee the independence and integrity of the data that feeds these models. Given the subjective decisions that go into developing and selecting the volatilities, correlations and illiquid forward curves that are used to calculate VaR, a skilled front or mid-office employee can easily manipulate VaR and MTM upward or downward . 10 The CCRO should have emulated the BIS 98 Qualitative Requirements, which recommend model parameters be estimated independently of trading desks. 11

Meanwhile, the CCRO provides no endorsement of valuation best practices. Interestingly, the valuation section of the CCRO recommendations provides little detail about energy instrument valuation methodology. For instance, while it is generally understood that energy prices are mean reverting 12 and that power prices are subject to price "jumps," the CCRO provides no recommendation that companies use mean reversion and/or jump diffusion as part of their valuation. This is an area ripe for manipulation, since energy companies can significantly manipulate the value of certain derivatives through the selection of valuation methodology.

[Editor’s Note: Jump diffusion is the process proposed by Robert Merton whereby the price of the underlying neither simply jumps nor follows a pure diffusion process but moves by a combination of a jump followed by continuous diffusion. Option pricing models have been extended to incorporate these kinds of jump price dynamics with directional bias, but there are still theoretical problems associated with jump diffusion models. For example, the underlying asset in a foreign exchange option is an exchange rate which can be denominated in either of two currencies. However, jump diffusion models do not give the same prices when compared in a common currency.]

The CCRO report does not provide a standard for stress testing, scenario, and sensitivity analysis. The CCRO spends considerable space in its recommendations to endorse and discuss stress-testing portfolios as a valuable supplement to VaR for risk measurement. In its recurring pattern of stopping short of progressive recommendations, the CCRO does not recommend running a standard set of stress tests, leaving the energy industry behind even the insurance industry, which has defined seven standard scenarios. 13

Credit and Disclosure

The credit and disclosure sections are somewhat better conceived, although not without imperfections. In the credit section the CCRO does a good job describing the basic Credit 101 mitigation techniques (e.g. netting contracts, collateral, etc.) but marginalizes the importance of information provided by bond market pricing, relying instead on credit rating agencies and internal financial analysis. The CCRO does mention that market bond