now I just mentioned there's something
else in finance called var actually III
have on this slide that it means two
things
it means variance and it means value at
risk but actually there's a third one
that's vector autoregressive but i won't
quote I was just thinking that it can be
confusing so the variance of a portfolio
we've defined is a measure of its
variability there's in finance some
people use var for Value at Risk and
this term is ret is relatively new it
didn't appear until after the stock
market crash of 1987 and so it's a
measure used by some finance people to
quantify risk of of an investment or of
a portfolio and it's it's quoted in
units of dollars for a given probability
and time horizon so for example if it
says there's a 1% one-year value at risk
of 10 million it means that there's a 1%
chance that the portfolio will lose 10
million in one year and then there's
another measure of risk that's that's
become popular in recent years
especially after the financial crisis of
2007 through 9 and that's called a
stress test now the term stress test
goes back to the 1960s or so and it
refers to something that your doctor
would order if he was worried about your
heart and he would have you get on a
treadmill in a medical facility and run
and they have an electric car D I'm
hooked up to you and they check out your
heart while you're under stress the
stress of running but now the term has
moved into finance so office of Federal
Housing Enterprise oversight actually
was doing stress tests on Fannie Mae and
Freddie Mac before the 2008 crisis
didn't work those two firms both failed
but they were trying anyway so a stress
test reflects the idea it's less
it's not a basic statistical concept
it's a measure it's a method of
assessing risk to firms or portfolios
the idea of a stress test is that let's
look at a portfolio not just by its
historical returns and how variable they
are but this look at the details of the
portfolio and ask what vulnerabilities
there are for various kinds of financial
crises because what actually stresses
firms the most our crises it's not just
normal variation and this is something
I'm going to come back to you later in
this lecture that there are extreme
events occur and so the stress test is a
is a test usually ordered by a
government to see how some firm will
stand up to a financial crisis so the
dodd-frank act in the United States of
2010 requires the Federal Reserve to do
annual stress tests for non-bank
financial institutions that supervises
they were I think they were already
doing them for banks and they wanted to
be at least three different economic
scenarios that would the Fed would
present so what they would do is they
would get information from the firm
about all of their interconnectedness
with other institutions everything they
owned how safe is it and they would look
at say for example what would happen if
there were a severe recession or what
would happen if the dollar depreciated
or appreciated or what would happen if
there's a short term liquidity crisis
was suddenly ability to borrow money at
the short-term dries up the dodd-frank
Wall Street Reform and Consumer
Protection Act was passed into federal
law on July 21st 2010 as a response to
the financial crisis of 2007 to 2008
this act constitutes the most
significant changes to US financial
regulation since the regulatory reform
that followed the Great Depression
the dodd-frank Act didn't specify what
the three different scenarios were but
they they did say that there should be
at least three so this is a different
story this is scenario analysis it's not
something that we're going to emphasize
in this course because it's because it's
more institutional details that get into
the calculations the European Banking
Authority which was created in 2011
after the financial crisis has also
instituted regular stress tests for
European banks the United Kingdom China
and other countries all do stress tests
now but the question is do they work
well there's a growing amount of
skepticism that they can really measure
what will happen in the next crisis so
Anat admati is a professor at Stanford
who's been arguing it's all garbage you
can't these guys who are trying to
predict what will happen to these
companies in a financial crisis they
just don't have the imagination and an
understanding of how things work out in
a panic in a financial panic and she
thinks that they are just way under
estimate generally the stress tests come
out saying it's okay don't worry it does
remind me I was on a stage with the
chief economist of Freddie Mac here at
Yale we had a it was around 2005 and he
was boasting about their stress tests
and he said that so I asked him what
about it what if there's a real estate
crisis and home prices fall a lot they
were there there are a company that
guarantees mortgages on homes and so he
said well we have figured out what would
happen to our portfolio even under
extreme stress situations so I said well
what what what what is your I did this
on stage not this stage it wasn't built
yet I said well what's the biggest price
decrease you
you ever considered for your stress test
he said oh you know we considered a 13%
drop in home prices and then I said to
him well what if it's bigger than that
and then he looked sugar in that he said
we've never seen home price drops not
not since the Great Depression you're
not talking about another depression are
you so we're still friends I still be
vacation but the problem is that home
prices fell 30 percent right after that
meeting or within a couple of years and
and these two companies Fannie and
Freddie that were considered safe Corp
well actually if you read the old fail
reports on the stress test back then
they'll say there is some concern still
you know they're hedging but basically
they said don't worry and then so that
was the end of a fail the government
shut it down so the question is whether
we can do it this time so are knotted
Madhi doubts that we can do it this time
she thinks there are bigger worries the
stress tests are all coming out as no
problem but she's not so sure we say if
I were CEO of a firm I imagine I would
ask for stress tests in doing an
internally but you don't want a public
what if it comes out bad see the problem
is that if you ever release that
information then all of your other
companies that might do business with
you are worried about that and so they
wouldn't want to do business with you so
it's like your reputation is at stake
so if the government demands that you
reveal information for a stress test you
have every incentive to try to whitewash
it and there so the question is whether
the regulators have enough incentive to
demand and push the dodd-frank Act gave
regulators the Office of Financial
Research subpoena power so they can go
in there and demand information from
firms but it's hard to get it I think in
the real world it's a battle they don't
want to tell you