Fooled by Randomness

Quote from intradaybill:

He is not right. Exchanges have risk only when they cannot deliver physical commodities, a totally unrelated situation to financial paper. Otherwise, they have no exposure to the instruments traded. They just collect fees by insuring sufficient counterparty collateral and adjusting it frequently based on market conditions. A real estate broker for example that has ho exposure to real estate can never fail. They may end up having no business but they can never fail due to debt accumulation.

Indirectly, he is arguing in favor of the bailout. These arguments are pure non-sense because they rest on hypothetical situations.

The fact of the matter is that probability of OTC transaction default is orders of magnitute greater than that in an organized exchange.
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You're wrong and nel-san is right...

Exchanges have daily counterparty exposure just like any other financial institution. There's nothing inherently different between an exchange facing a client on a position and a bank facing a client on an OTC trade. The proper analogy is with a real-estate broker that makes a deposit on behalf of a client.

Problems with OTC risk management have to do with transparency and the possibility of abuse, rather than outright counterparty risk.
 
Quote from Martinghoul:

Again, I disagree...

1. Just saying "too big to fail = bad" is not prescriptive, very vague and hardly original. Everyone and their mother has been saying that and some, like NNT, were saying that before the crisis. The devil's in the details. How do you define "too big"? How do you prevent institutions from getting too big? How do you reconcile real "economies of scale" efficiency gains with increased systemic risks? Moreover, if there's regulation to prevent institutions from getting too big, how do you avoid regulatory capture and arbitrage? It's easy to be a 'big picture' guy and there's a lot of those around, including NNT.

2. What specifically is his approach to the mkts? That extreme events in the mkt cannot ever be predicted, that they are unknowable and therefore trying to understand what happens when things are in or near collapse is futile? I say that's either a bullsh1t copout or a publicity stunt. As I keep saying again and again, science is EXACTLY about trying to "impose structure and limit on something that inherently seems to have none". If we keep assuming that anything beyond the pale of our current understanding is unknowable, we will never get anywhere. Luckily, there are good academics out there and they keep trying (I have given examples). They're the ones that should be in the spotlight and not NNT. As to the comparison to Scholes&Merton, I don't know what that has to do with anything. That's like saying that NNT is better than Isaac Newton, just because the latter lost a fortune in the South Seas bubble. Individuals' real-life economic decisions and their contribution to human progress are two very different things.
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1. You're right, not an idea original with him. Doesn't mean he isn't right. Saying that the devil is in the details is silly: life is all about trying things until you get it right. As of now, though, despite the fact it's common knowledge we have banks too big to fail, we just keep making them bigger. There's a reason he repeats himself, a very good reason.
2. No, what he's saying isn't just that they're not predictable, he's also saying they happen more often than people will admit. Thus, we've had, during the time I've been active, the biggest one day crash ever (Oct 87), a mini crash just a few years later (Oct 90), the fall of Communism (1989-1991), the British currency crisis where Soros broke the Bank of England and made a nice piece of money (1992), the Mexican Tequila crisis (1995), the Asian financial crisis (1997), the Russian default that did in LTCM (1998), 9/11, which happened right in the middle of a big fall in the Nasdaq from which it has yet to recover, and finally this one we're going through now.
So, his point is life is full of unexpected events, and his strategy, he claims, is to put himself in a position to profit from the unexpected by buying out of the money options and waiting. He claims out of the money options are chronically mispriced. I don't know if he makes money or not doing this, but that's not the point: he does point out that option sellers, like Neiderhoffer (who blew up in '97 because of the Asian financial crisis, and again in '07 because of this one), repeatedly blow up because they don't expect the unexpected, and trade that way, and that this is empirical proof that out of the money options are mispriced.
That's a prescription leading to a strategy to follow, and a strategy not to follow. Neither I nor anyone else would expect him to be more specific about what he does, because obviously that's his own business. That doesn't mean he's not telling you both what he does and what he doesn't do and why.
 
BTW, Merton/Scholes blowing up LTCM is highly relevant, as that happened because, once again, they assumed no counterparty risk, the counterparty in this case being the Russian government. And here we are debating counterparty risk, again.
 
Quote from trefoil:

1. You're right, not an idea original with him. Doesn't mean he isn't right. Saying that the devil is in the details is silly: life is all about trying things until you get it right. As of now, though, despite the fact it's common knowledge we have banks too big to fail, we just keep making them bigger. There's a reason he repeats himself, a very good reason.
2. No, what he's saying isn't just that they're not predictable, he's also saying they happen more often than people will admit. Thus, we've had, during the time I've been active, the biggest one day crash ever (Oct 87), a mini crash just a few years later (Oct 90), the fall of Communism (1989-1991), the British currency crisis where Soros broke the Bank of England and made a nice piece of money (1992), the Mexican Tequila crisis (1995), the Asian financial crisis (1997), the Russian default that did in LTCM (1998), 9/11, which happened right in the middle of a big fall in the Nasdaq from which it has yet to recover, and finally this one we're going through now.
So, his point is life is full of unexpected events, and his strategy, he claims, is to put himself in a position to profit from the unexpected by buying out of the money options and waiting. He claims out of the money options are chronically mispriced. I don't know if he makes money or not doing this, but that's not the point: he does point out that option sellers, like Neiderhoffer (who blew up in '97 because of the Asian financial crisis, and again in '07 because of this one), repeatedly blow up because they don't expect the unexpected, and trade that way, and that this is empirical proof that out of the money options are mispriced.
That's a prescription leading to a strategy to follow, and a strategy not to follow. Neither I nor anyone else would expect him to be more specific about what he does, because obviously that's his own business. That doesn't mean he's not telling you both what he does and what he doesn't do and why.
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1. I never said he was wrong. I only said he was unoriginal and doesn't deserve great acclaim for saying what he's saying. I also don't understand why it's silly to ask for more specific approaches to solving the 'too big to fail' issue. Again, anyone can say that 'too big to fail' is bad. That's what I call proscriptive. How to define 'too big' and how to prevent institutions from getting too big, that's prescriptive and I don't hear NNT making any worthwhile suggestions. Think of it this way, maybe it's precisely because pundits like NNT keep repeating the same useless generalities that nothing has actually improved. Furthermore, I was just thinking that, like others, NNT is actually rather off the mark with 'too big to fail'. What if you have a very large number of small financial institutions failing due to having similar/correlated exposure, like banks during the Great Depression? While each of them individually can be small, their simultaneous failure can bring the system down just as well as a failure of a huge bank. That's why I say that devil's in the details and I don't see how it's a silly thing to say.

2. Fine, I understand his point about fat tails, "outstrike" events occurring more often than people price in etc etc. But that's vague and doesn't make any sense as an actual strategy. What exactly is he saying that actually helps one make a decision? Should OTM options always be bought, regardless of price? Should one never ever sell OTM options? Is it possible to predict the regime shifts? Again, there's lots of people doing research on debt accumulation cycles that are actually thinking about these issues in much more specific terms than NNT.

Let me give you a specific example: the Black Swan fund, named after Taleb's concept, made a lot of money last year by buying outstrike options. However, what do they say now? "36 South plans to close its Black Swan Fund within the next two months and return the money to investors as options are now “very expensive” and are unlikely to produce “significant returns,” Haworth said." So clearly any realistic investor or manager cannot just say "OTM options always cheap". They have to have a measure that can be used to determine what's cheap, what's expensive. Does NNT offer insight into how to formulate this measure? No... That's my problem with him.
 
Quote from trefoil:

BTW, Merton/Scholes blowing up LTCM is highly relevant, as that happened because, once again, they assumed no counterparty risk, the counterparty in this case being the Russian government. And here we are debating counterparty risk, again.
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Huh? They never faced the Russian gov't...

The problem was not the Russian default (how many people do you think were really exposed to the GKOs that Russia actually failed on), but rather the resulting flight-to-quality into USTs.

The problem is not cpty risk. Problem is a panic that causes liquidity to evaporate and mkts that stop being complete as a result.
 
The triggering event was the Russian default. They made the same mistake Walter Wriston made a generation ago when he said "countries don't go broke."
Of course they do, and sometimes at the most inconvenient times.
As to him closing his fund, as I said, I don't know whether he's actually successful or not. I'm just pointing out that he does have a prescription, follows it in real life, and, amazingly enough, has never needed a government bailout. Also, I didn't expect specifics because that would be giving away for free a strategy I'm sure he's spent some time refining, at least enough time to know when options are expensive enough for it not to work, as your citation shows.
 
Quote from trefoil:

The triggering event was the Russian default. They made the same mistake Walter Wriston made a generation ago when he said "countries don't go broke."
Of course they do, and sometimes at the most inconvenient times.
As to him closing his fund, as I said, I don't know whether he's actually successful or not. I'm just pointing out that he does have a prescription, follows it in real life, and, amazingly enough, has never needed a government bailout. Also, I didn't expect specifics because that would be giving away for free a strategy I'm sure he's spent some time refining, at least enough time to know when options are expensive enough for it not to work, as your citation shows.
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Very well...

If what you suggest is true, why don't we treat his prescriptions, ideas and views the same way as opinions of other hedge fund traders and managers that never needed a bailout, like Jim Rogers, Marc Faber etc? Why is it that people keep treating NNT's views as more than a guy talking his book? Why do people listen to him when he positions himself as some sort of a super-academic, a financial theorist par excellence and a philosopher to boot?

If he's just a hedge fund dude, don't you think this line (from his website) sounds just a bit pretentious:
"My activism: a) To "robustify" society against Black Swans --activism against those who fragilize it (bankers, economists etc.)"? (and why, for god's sake, does he have to mangle the English language with words like 'fragilize')

Anyways, I really don't have a problem with anyone who likes NNT listening to him. Personally, I don't, because there are lots of worthier people to listen to. 'Nuff said...
 
Quote from dtrader98:

...TDOG (inadvertently?) stumbled upon a good pragmatic maxim, in that generalization is more important than precision when looking forward. An issue that is already being addressed by those who deal with these ideas from a modern approach...
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(Ahem)...Not quite so "inadvertently." :p

I have always admonished numeric specificity when it comes to predicting or forecasting the direction or magnitude of price movement in financial markets. Although I am nowhere near the cutting edge when it comes to these matters, I still regard such exactitude as wishful thinking at best and dangerous at worst.
 
Quote from Thunderdog:

(Ahem)...Not quite so "inadvertently." :p

I have always admonished numeric specificity when it comes to predicting or forecasting the direction or magnitude of price movement in financial markets. Although I am nowhere near the cutting edge when it comes to these matters, I still regard such exactitude as wishful thinking at best and dangerous at worst.
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We must conclude you're not French then, T-dawg :)...
 
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