On Goldman’s fat tail risk

Zero Hedge points us in the direction of a risk management presentation from Goldman Sachs.

The majority of slides are typical management-type stuff. There are some impressive Venn diagrams and graphics of interlocked puzzle pieces, as well as a few intriguing comments on mark-to-market accounting, but the most interesting thing, we think, is the slide on fat tails and Value at Risk, or VaR.

VaR is a way of measuring the risk of loss on a portfolio, using observations of historical market movements, with the VaR model used by Goldman Sachs looking at 95 per cent and 99 per cent tail risk. Tail risk is the the ‘unexpected’ losses or gains that happen to the portfolio, assuming normal distributions.

In the three months to March 27, 2009 Goldman’s VaR value was $240m at the 95th percentile. Meaning there was a 5 per cent probability Goldman’s portfolio would fall in value by more than $240m over a one day period. That compares with a VaR value of $197m in the three months to November 28th, 2008, and a VaR of $157m in the three months to February 29th, 2008 (Goldman Sachs, we all remember, conveniently changed its reporting period).

In any case, here’s the fat tail slide from Goldman’s risk presentation:

And here’s Zero Hedge’s commentary:

. . . the fat tail analysis is also somewhat non-self explanatory. As the chart [above] indicates that Goldman is dead set on analyzing the 99 percentile (in addition to the 95%) non-fat tail distribution. Does this explain the meteoric rise in VaR in recent reporting periods? Also - what happens on that rare 100th day, week, month? Especially if there is nobody left to bail you out.

The rise in VaR, we think, is explained by the below slide from the same presentation, which shows the illiquidity in recent market environments and an example of a crowded trade — when investors rush to unwind their positions simultaneously — in the form of the notorious Volkswagen short squeeze of death.