AIM:  Describe how risk can be mis-measured.

The first step in risk management is to measure risk. Two types of measurement mistakes can be made:

• Known risks can be mis-measured,
• Some risks can be ignored

When measuring risk, risk managers attempt to understand the distribution of possible returns. In specifying the distribution, mistakes include:

• To select the wrong distribution
• To specify the distribution incorrectly
• The dependencies between distributions can be mismeasured (“correlations may be mis-measured.”)

A vexing problem is the application of historical data:

• Historical sample does not apply
• No relevant sample may exist (“with the subprime crisis, there was no historical data of a downturn in the real estate market during which a large amount of securitized subprime mortgages was outstanding.”)

Helpful Tip:  As Stulz writes, “with the subprime crisis, there was no historical data of a downturn in the real estate market during which a large amount of securitized subprime mortgages was outstanding. In such a situation, risk measurement cannot be done by simply using historical data … With such a case, statistical risk measurement reaches its limits and risk management goes from science to art … [assessments] have a significant element of subjectivity.

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