Sophisticated measurement techniques can help greatly in providing insights about the dimensions of risk and sources of possible problems. But, like chains, models are only as strong as their weakest links. Every model has assumptions that must be tested, and its limitations must be understood. During periods of market stress nearly “all bets are off”.
Business practices change, otherwise stable and expected correlations in market rates and prices disappear, and sometimes panic ensues. Well thought out and designed contingency plans and scenario analysis tailored to specific strategies and portfolios are necessary to prepare for these events and to evaluate an institution’s risks. That point was brought home last year.