Tag Archive for 'finance'

Economist on fat tails and finance

Published
by
Garry Peterson
on February 17, 2009
in Regime Shifts
. 1 Comment

A special report on the future of finance in The Economist Fallible mathematical models: In Plato’s cave:

… although the normal distribution closely matches the real world in the middle of the curve, where most of the gains or losses lie, it does not work well at the extreme edges, or “tails”. In markets extreme events are surprisingly common—their tails are “fat”. Benoît Mandelbrot, the mathematician who invented fractal theory, calculated that if the Dow Jones Industrial Average followed a normal distribution, it should have moved by more than 3.4% on 58 days between 1916 and 2003; in fact it did so 1,001 times. It should have moved by more than 4.5% on six days; it did so on 366. It should have moved by more than 7% only once in every 300,000 years; in the 20th century it did so 48 times.

In Mr Mandelbrot’s terms the market should have been “mildly” unstable. Instead it was “wildly” unstable. Financial markets are plagued not by “black swans”—seemingly inconceivable events that come up very occasionally—but by vicious snow-white swans that come along a lot more often than expected.

This puts VAR in a quandary. On the one hand, you cannot observe the tails of the VAR curve by studying extreme events, because extreme events are rare by definition. On the other you cannot deduce very much about the frequency of rare extreme events from the shape of the curve in the middle. Mathematically, the two are almost decoupled.

The drawback of failing to measure the tail beyond 99% is that it could leave out some reasonably common but devastating losses. VAR, in other words, is good at predicting small day-to-day losses in the heart of the distribution, but hopeless at predicting severe losses that are much rarer—arguably those that should worry you most.

When David Viniar, chief financial officer of Goldman Sachs, told the Financial Times in 2007 that the bank had seen “25-standard-deviation moves several days in a row”, he was saying that the markets were at the extreme tail of their distribution. The centre of their models did not begin to predict that the tails would move so violently. He meant to show how unstable the markets were. But he also showed how wrong the models were.

Modern finance may well be making the tails fatter, says Daron Acemoglu, an economist at MIT. When you trade away all sorts of specific risk, in foreign exchange, interest rates and so forth, you make your portfolio seem safer. But you are in fact swapping everyday risk for the exceptional risk that the worst will happen and your insurer will fail—as AIG did. Even as the predictable centre of the distribution appears less risky, the unobserved tail risk has grown. Your traders and managers will look as if they are earning good returns on lower risk when part of the true risk is hidden. They will want to be paid for their skill when in fact their risk-weighted returns may have fallen.

Willful ignorance and the financial crisis - part 2

Published
by
Garry Peterson
on November 28, 2008
in Ideas
. 0 Comments

Gretchen Morgenson writes on the roots of the collapse of Merrill Lynch in How the Thundering Herd Faltered and Fell as part of a New York Times series on the financial crisis:

“In 1997 and 1998, when we invented super senior risk, we spent a lot of time examining how much is too much to have on our books,” said Blythe Masters, who was on the small team that invented the synthetic C.D.O. and is now head of commodities at JPMorgan Chase. “We would warehouse risk for a period of time, but we were always focused on developing a market for whatever we did. The idea was we were financial intermediaries. We weren’t in the investment business.”

For years, the product that Ms. Masters and her colleagues invented remained just a mechanism for offloading risk in high-grade corporate lending. But as often occurs with Wall Street alchemy, a good idea started to be misused — and a product initially devised to insulate against risk soon morphed into a device that actually concentrated dangers.

… By 2005, with the home lending mania in full swing, the amount of C.D.O.’s holding opaque and risky mortgage assets far exceeded C.D.O.’s composed of blue-chip corporate loans. And inside even more abstract synthetic C.D.O.’s, the risk was harder to parse and much easier to overlook.

Similarly, in the same series on the financial crisis, Eric Dash and Julie Creswell write on the collapse of Citibank in Citigroup Saw No Red Flags Even as It Made Bolder Bets:

… many Citigroup insiders say the bank’s risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers eager to increase short-term earnings — and executives’ multimillion-dollar bonuses — failed to rein them in, these insiders say.

…While much of the damage inflicted on Citigroup and the broader economy was caused by errant, high-octane trading and lax oversight, critics say, blame also reaches into the highest levels at the bank. Earlier this year, the Federal Reserve took the bank to task for poor oversight and risk controls in a report it sent to Citigroup.

… regulators have criticized the banking industry as a whole for relying on outsiders — in particular the ratings agencies — to help them gauge the risk of their investments.

“There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk,” John C. Dugan, the head of the Office of the Comptroller of the Currency, the chief federal bank regulator, said in a speech earlier this year.

Ecology for bankers

Published
by
Garry Peterson
on February 20, 2008
in Ecological Economics, Networks and Regime Shifts
. 4 Comments

In Feb 21 2008 Nature, ecologists Robert May, Simon Levin, and George Sugihara write about how ecological thinking can be used to illuminate financial dynamics in their commentary Complex systems: Ecology for bankers:

‘Tipping points’, ‘thresholds and breakpoints’, ‘regime shifts’ — all are terms that describe the flip of a complex dynamical system from one state to another. For banking and other financial institutions, the Wall Street Crash of 1929 and the Great Depression epitomize such an event. These days, the increasingly complicated and globally interlinked financial markets are no less immune to such system-wide (systemic) threats. Who knows, for instance, how the present concern over sub-prime loans will pan out?

Well before this recent crisis emerged, the US National Academies/National Research Council and the Federal Reserve Bank of New York collaborated on an initiative to “stimulate fresh thinking on systemic risk”. The main event was a high-level conference held in May 2006, which brought together experts from various backgrounds to explore parallels between systemic risk in the financial sector and in selected domains in engineering, ecology and other fields of science. The resulting report was published late last year and makes stimulating reading.

Catastrophic changes in the overall state of a system can ultimately derive from how it is organized — from feedback mechanisms within it, and from linkages that are latent and often unrecognized. The change may be initiated by some obvious external event, such as a war, but is more usually triggered by a seemingly minor happenstance or even an unsubstantial rumour. Once set in motion, however, such changes can become explosive and afterwards will typically exhibit some form of hysteresis, such that recovery is much slower than the collapse. In extreme cases, the changes may be irreversible.

…

Two particularly illuminating questions about priorities in risk management emerge from the report. First, how much money is spent on studying systemic risk as compared with that spent on conventional risk management in individual firms? Second, how expensive is a systemic-risk event to a national or global economy (examples being the stock market crash of 1987, or the turmoil of 1998 associated with the Russian loan default, and the subsequent collapse of the hedge fund Long-Term Capital Management)? The answer to the first question is “comparatively very little”; to the second, “hugely expensive”.

Taleb on the failures of financial economics

Published
by
Garry Peterson
on October 27, 2007
in Reorganization and Vulnerability
. 2 Comments

Nassim Nicholas Taleb writes in Financial Times that because financial economics focus on normal and marginal behaviour at the expense of shocks and market reorganizations it is a pseudo-science hurting markets:

I was a trader and risk manager for almost 20 years (before experiencing battle fatigue). There is no way my and my colleagues’ accumulated knowledge of market risks can be passed on to the next generation. Business schools block the transmission of our practical know-how and empirical tricks and the knowledge dies with us. We learn from crisis to crisis that MPT [modern portfolio theory] has the empirical and scientific validity of astrology (without the aesthetics), yet the lessons are ignored in what is taught to 150,000 business school students worldwide.

Academic economists are no more self-serving than other professions. You should blame those in the real world who give them the means to be taken seriously: those awarding that “Nobel” prize.

In 1990 William Sharpe and Harry Markowitz won the prize three years after the stock market crash of 1987, an event that, if anything, completely demolished the laureates’ ideas on portfolio construction. Further, the crash of 1987 was no exception: the great mathematical scientist Benoît Mandelbrot showed in the 1960s that these wild variations play a cumulative role in markets – they are “unexpected” only by the fools of economic theories.

Then, in 1997, the Royal Swedish Academy of Sciences awarded the prize to Robert Merton and Myron Scholes for their option pricing formula. I (and many traders) find the prize offensive: many, such as the mathematician and trader Ed Thorp, used a more realistic approach to the formula years before. What Mr Merton and Mr Scholes did was to make it compatible with financial economic theory, by “re-deriving” it assuming “dynamic hedging”, a method of continuous adjustment of portfolios by buying and selling securities in response to price variations.

Dynamic hedging assumes no jumps – it fails miserably in all markets and did so catastrophically in 1987 (failures textbooks do not like to mention).

Later, Robert Engle received the prize for “Arch”, a complicated method of prediction of volatility that does not predict better than simple rules – it was “successful” academically, even though it underperformed simple volatility forecasts that my colleagues and I used to make a living.

The environment in financial economics is reminiscent of medieval medicine, which refused to incorporate the observations and experiences of the plebeian barbers and surgeons. Medicine used to kill more patients than it saved – just as financial economics endangers the system by creating, not reducing, risk. But how did financial economics take on the appearance of a science? Not by experiments (perhaps the only true scientist who got the prize was Daniel Kahneman, who happens to be a psychologist, not an econ­omist). It did so by drowning us in mathematics with abstract “theorems”. Prof Merton’s book Continuous Time Finance contains 339 mentions of the word “theorem” (or equivalent). An average physics book of the same length has 25 such mentions. Yet while economic models, it has been shown, work hardly better than random guesses or the intuition of cab drivers, physics can predict a wide range of phe­nomena with a tenth decimal precision.

via 3quarks daily.

For more see Taleb’s home page - Fooled by Randomness.