“Risk managers are supposed to rely on hard data, but what happens when a gut feeling is more accurate? A new note from consultants at Capital Market Risk Advisors (CMRA) suggests that one of the big lessons of the covid era is that risk managers should follow their hunches even if the data hasn't caught up yet.
Interviews with risk managers conducted by CMRA suggest that while markets were aware of a potential threat from the coronavirus in January, few risk models took it seriously. The threat was vague and hard to quantify, which meant risk managers put off doing stress tests that considered its potential impact until it was almost too late […]
The pandemic also highlighted how risk management needs to adapt in its response to an extreme event. It's not enough to include updated volatility in models, instead, risk managers should be stress testing every day until markets return to calm, the note says. In most cases, stress tests happen bi-annually or sometimes quarterly, but that may not be frequent enough to reflect a wholesale change in the market regime. CMRA notes that risk models rely on correlations within historical data. Volatile markets provide the precise environment to ensure that historical risk models are still valid. Testing during volatility may also unearth new historical correlations and risk insights that can prove valuable to portfolio management going forward.