0.2 Voldemort and the Second Edition
The first edition of this book was published in hardcover by Acadeic Press/Elsevier in 2003. Readers of my blog are familiar with the bizarre circumstances that caused that first edition to be abruptly pulled from the market. A consistent pattern of problems had emerged with the book’s marketing and distribution. For example, the publisher distributed an incorrect ISBN number. They distributed incorrect shelving instructions for the book, indicating that bookstores should shelve it under marketing or radical economics. The book was not cataloged with the US Library of Congress.
Eventually, I sat down and wrote a list of all the things someone might do if they wanted to sabotage the marketing for a book. I then investigated how this book was being marketed and found that every item on that list had occurred. The book had not been listed it the catalog Books In Print. Professors who requested review copies never received them, even after repeated requests and intervention by me. Misinformation was posted to on-line bookstores. The list went on and on.
Behind the scenes, the author of a competing book on value-at-risk lurked. Dubbed “Junior” by me and “Voldemort” by one reader of my blog, this ethically challenged individual had a prior business relationship with one employee of the publisher. I won’t hazard a guess as to whether Junior paid bribes. I can think of no other explanation.
The situation was so bizarre and extreme that, when I approached the publisher’s senior management, they readily gave me back the copyright to the book. The book was pulled from the market, causing the price of used copies available on-line to skyrocket to over $1,000. This unsatisfactory state of affairs persisted for a few years because I didn’t have time to deal with it. I eventually decided that the only way to ensure people had access to the book was to post it for free on the Internet.
That was my plan. This second edition came about because a number of people mentioned that, even with the book freely available on the Internet, they would gladly pay for a hardcover copy they could hold in their hands—this was back in 2009 when e-books were still a novelty. I found time to approach a new publisher, Chapman & Hall/CRC, and we decided that we would produce a hardcover second edition to supplement the free on-line first edition. As things turned out, it is the new second edition that you are now reading for free on-line. I will explain how that happened below, but first let me tell you what is new in the second edition.
Much is new. Four new chapters cover historical simulation, implementation, model risk and backtesting. Chapters 3 and 4 have been expanded with new material on probability and statistics. Other minor changes appear throughout the book. There are 22 new exercises, with solutions provided. Scattered amidst the new content, I have provided new details about the history of value-at-risk as well as a number of personal anecdotes from my consulting work.
In the first edition, I defined value-at-risk more broadly than most authors. While the common definition of value-at-risk is that it represents a quantile of loss over some specified horizon, my definition encompassed many other probabilistic metrics of market risk, including expected tail loss (ETL) and variance of return. I embraced the broader definition because the computations to calculate value-at-risk, ETL, variance of return and other metrics are essentially identical. They differ only in the very last step. Accordingly, techniques described in this book can be used to calculate any of these metrics, which is why I extended the definition of value-at-risk in the first edition to encompass them all. There was, however, some protest over that decision. In this second edition, I revert to the common definition. I now use the term “probabilistic metric of market risk” (PMMR) to refer to the broader category or market risk metrics that includes value-at-risk, ETL and variance of return, among others. See Section 1.4.
Notation remains unchanged from the first edition with one exception. Readers familiar with the first edition will notice at the end of Section 4.6.1 that I have modified how I use tildes to denote conditional distributions.
It has become customary to use the term “value-at-risk” to refer to any quantile-of-loss metric of financial risk, so people speak of value-at-risk metrics of credit risk or value-at-risk metrics of operational risk. I am less extravagant. In the first edition, I stated firmly that I defined value-at-risk as applicable to market risk only. At the time—back in 2003—“credit VaR” measures were flourishing. These are measures of credit risk that purport to reflect, say, the 0.99 quantile of a portfolio’s one-year loss to defaults. The fact is that defaults evolve over a business cycle, and one business cycle is different from the next. A 0.99 quantile of a portfolio’s credit risk would be the loss due to defaults that a portfolio would be expected to suffer over a particular year at a particular stage of one business cycle out of a hundred business cycles. Even if we had twenty years of relevant default data for each instrument or issuer, that would only represent three to five business cycles—too few data points to have statistical relevance. Such meager data cannot possibly support claims about a portfolio’s 0.99 quantile of one-year loss due to defaults. I don’t care how elaborate the mathematics of these measures might be. Mathematics is no substitute for empirical data. Any assertions about the 0.99 quantile of a portfolio’s one-year loss due to defaults is meaningless. In other words, most so-called credit VaR measures are meaningless. We don’t have to consider their analytics to reach this conclusion. It follows immediately from the paucity of default data.
This was my position in 2003. The 2008 meltdown in credit markets vindicated that position. Credit VaR measures, and related credit pricing models, spectacularly failed to warn of what was coming. Now there is talk of “building better models.” Such chatter is inevitable, I suppose, but it is nonsense. Truth be told, there was never any risk in the collateralized debt obligations (CDO’s) that crippled the credit markets in 2008. They were guaranteed to fail. If you jump from an airplane without a parachute, you aren’t taking risk. There is no uncertainty about the outcome. We don’t need models to tell us any of this.
A strength of this book is its numerous real-world examples from capital, energy and commodity markets. Some of these were historical examples. Others were current, at least for 2003. Much has changed in a decade. Due to a wave of mergers, many exchanges mentioned in those examples no longer exist as independent entities. A few instruments also no longer exist or otherwise lack the liquidity they once had. I have not updated examples to reflect such changes. What would be the point? Further changes would soon render even the updated examples outdated. I merely ask readers to treat outdated examples as historical examples. All retain the relevance and insights that they had a decade ago.
As I sent the manuscript for the second edition to Chapman & Hall/CRC, I was mindful that publishing is an insular business. People know each other from one publisher to the next. If bribes motivated the problems at the old publisher, they might purchase problems at the new publisher. I monitored developments closely and was disappointed when irregularities soon emerged with advance marketing for the second edition. As with the previous publisher, I received ever more elaborate excuses as problems mounted. For me, the clincher was when “author information” appeared on on-line bookstores, erroneously indicating I was a professor at the University of Maryland. This was a minor “mistake”, but the publisher of the first edition had done exactly the same thing, erroneously indicated that I was a professor at the University of Washington. The stark similarity of these two supposedly random “mistakes”—coming on top of everything else—had the feel of someone thumbing his nose at me … dropping an unmistakable hint that Voldemort was back in the driver’s seat. I approached the new publisher’s management and proposed we terminate our publishing agreement, even before the second edition went to press. They did the expedient thing and agreed. That is how I decided to make the entire second edition available for free on the Internet.