For those of you who do not know, VaR is Value at Risk and a measure of daily market risk in a position. JPM's risk management system was working according to theory when it measured the risk in the position that has cost the firm $2.0 bn already and much more in stock market value and reputation.
The VaR in the position according to press reports was $178 mm. But VaR assumes that reversion to the mean happens eventually and one cannot always hold a position until that happens. And that is what stress tests are supposed to measure. However, there has been no release to the public as what the expected loss in a stress scenario was. And what we do know is that the position started to lose between $150mm and $200 mm a day for 10 to 15 business days resulting in the MTM loss passing through the income statement. So while VaR was working, someone forgot that the stomach to hold the position until mean reversion happened might not be present and MTM losses might become real losses. In fact, we don't know what JPM has done with the positions so they may still recover the loss or lose more on it.
What quantitative risk managers forget is common sense. A position may be too large for the market to absorb if reversed. Therefore, limits have to take into account the time it takes to unwind a position and the loss that might occur over that time period. VaR is daily measure and is fatally flawed when only used on a daily basis.
I know that JPM knows this stuff and the real mystery is why they did not apply it in this instance. I presume Jamie is working to make sure this does not happen again.
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