The currency by which one measures value will be the ultimate way of measuring risk. Furthermore, the recent increase in currency dilution because of rampant money printing has and will continue to result in currency debasement.
This process is happening to virtually every major currency, but it is often not readily observable because the devaluations occur relative to one another since all currencies are traded in pairs in the forex market.
The Pound Sterling has been a notable recent victim of currency debasement practices by the Bank of England, falling over fifteen big figures or losing roughly 9.5% of its value relative to the U.S. dollar in just over two months. The British currency fell from an intermediate peak of 1.6380 seen on Dec. 30 of 2012 down as far as the 1.4830 level by March 3.
Value at Risk or VaR Defined
Value at Risk or VaR is often used by financial analysts and risk managers to measure the risk of loss for a trading or investment portfolio. The VaR for a portfolio is typically expressed in term of the portfolio’s base currency, such as U.S. dollars.
For a particular portfolio, probability level and time frame, the VaR amount marks the loss threshold where the chances that portfolio experiences such a loss over the specified time frame is at the chosen probability level given normal trading conditions and no portfolio changes.
An example of a VaR risk assessment would be a portfolio of investment assets that has a one day two percent VaR of $500,000. This VaR would imply that the portfolio has a two percent chance — or a 0.02 probability — of experiencing a $500,000 loss over a one day time frame without any transactions occurring.
In using the VaR, many portfolio managers have apparently ignored 2,500 years of experience in favor of untested risk models built by non-traders. Some critics of this risk parameter believe relying on the VaR is akin to charlatanism because it claimed to estimate the risk of a portfolio, without taking into account the importance of rare events.
The use of VaR as a risk assessment applied to portfolios to help gauge relative safety often gives investors false confidence and can be exploited by traders, despite the non-zero risk of rare events occurring.
More recently, David Einhorn and Aaron Brown debated the use of VaR in Global Association of Risk Professionals Review . In the piece, Einhorn compared VaR to “an airbag that works all the time, except when you have a car accident.” He further charged that VaR:
(1) Led to excessive risk-taking and leverage at financial institutions.
(2) Focused on the manageable risks near the center of the distribution and ignored the tails.
(3) Created an incentive to take “excessive but remote risks”.
(4) Was “potentially catastrophic when its use creates a false sense of security among senior executives and watchdogs.”
Even In the minds of the most bearish, it is nearly impossible to account for the ultimate VaR — the risk of a global U.S. dollar devaluation. For the most part, the world still values its most important assets in terms of U.S. dollars. Still, at the same time, not a week goes by without investors hearing strong anti-dollar rhetoric, often accompanied by direct movement out of or away from using U.S. dollars in transactions.
Despite all of the complex equations and algorithms used by risk managers to assess their portfolios’ risk of loss, in the end, this is all theoretical math and not reality. While the math can be useful for comparison purposes, the concepts used to develop the equations are backed by faith, hope, fear and ignorance.
The risk management situation seems no different now for investors than it was 100 or even 1,000 years ago. The numbers may be bigger and the calculations fancier, but risk assessment is really no more sophisticated at its foundation.