Fooled by Randomness

[nelsanity]

One gaffe these folks make is believing how deeply randomness is a part of markets.

Take the popular phrase "fooled by randomness" and it's discussion in this thread.

Even Geometric Brownian Motion's application to Finance for that matter is a theory...not fact

What ever happened to prices and returns being determined by decisions, namely good management and stable investment. And what about Fed policy, international trade agreements, tax policy etc...Are those R.V.s?

No offense to academia, as I used be apart of it, but just because someone puts an interesting title on a book, uses some elegant theory and yet turns a blind eye so they can make some pretty gross assumptions to get to their "elegant" theory / model doesn't mean it's gospel. It just means they have some knowledge and found a way to put a novel twist on it to sell a few books. Sacrificing complexity to obtain an elegant closed form solution is definitely overrated. Current economic crisis case and point!

 

[Martinghoul]

Quote from nelsanity:


No offense to academia, as I used be apart of it, but just because someone puts an interesting title on a book, uses some elegant theory and yet turns a blind eye so they can make some pretty gross assumptions to get to their "elegant" theory / model doesn't mean it's gospel. It just means they have some knowledge and found a way to put a novel twist on it to sell a few books. Sacrificing complexity to obtain an elegant closed form solution is definitely overrated. Current economic crisis case and point!

Wait a sec, but that's exactly the charge that NNT levels at the academics? Are you now accusing him of doing the exact thing that is so anathema to him?

dtrader, Swan Noir: as far as I can tell you're saying the same thing.

Point is that wherever the current models' problems exist, whether it's the analytical approximations or the ability to extract signal from the noise, I just don't see the reason to assume that we're never going to be able to do any better. To me that's what NNT's rants boil down to, which is why I refuse to take him seriously.

 

[trefoil]

This is a gross oversimplification.
A couple of things:

1 - He has plenty of prescriptions. One of them, which popped up in The Black Swan book itself, was the suggestion that very large financial companies operating in a globalized environment were inherently dangerous. This was written before the crisis, by the way.
As Christopher Caldwell observes in today's FT:

Beware blind faith in bigness

By Christopher Caldwell

Published: August 21 2009 19:40 | Last updated: August 21 2009 19:40

If there is a slogan or catchphrase that sums up the way the world’s mind has changed in the past year, it is “too big to fail”. When governments rushed to the aid of failing financial institutions last autumn, everyone sensed there was something wrong with the way our societies and economies were organised. For a while, the world appeared to have rediscovered a lot of age-old wisdom about hubris and excess. Yet we have lost the sense that big institutions can be a problem even when they are not failing. Managing bigness is always a problem because big companies, big organisations, big political units, tend to narrow the individual initiative of those who belong to them.

As of now, we have large zombie banks whose employees now know they are government bureaucrats, but who still continue to act as if they're not. Obviously, this needs to be stopped.

2 - He is skeptical even of distributions that take into account fat tails, because he figures we may be imposing a structure and a limit on something that inherently doesn't have one. His approach to the markets incorporates this, and is surely a prescription. Scholes and Merton, when they blew up in 1998, nearly took the financial world with it. I don't know how well Taleb does, but I've never seen his name mentioned as a bailout recipient. That surely scores one for him.

 

[trendlover]

In this paper we explain how a plain vanilla and binary credit default swap can be val-
ued assuming no counterparty default risk. Like most other approaches, ours assumes that
default probabilities, interest rates, and recovery rates are independent. Unfortunately,
it does not seem to be possible to relax these assumptions without a considerably more
complex model. However, we are able to reach some general conclusions about the impact
of the assumptions on CDS valuations.

http://www.rotman.utoronto.ca/~hull/DownloadablePublications/CredDefSw1.pdf



So is this saying the model for credit default swap has nothing in that model for a counterparty risk? That model is what financial people use, and it only will work if the counterparty does not default?
If that is what they are saying, then a black swan is not what happened to the financial world.

 

[intradaybill]

Quote from trendlover:

In this paper we explain how a plain vanilla and binary credit default swap can be val-
ued assuming no counterparty default risk. Like most other approaches, ours assumes that
default probabilities, interest rates, and recovery rates are independent. Unfortunately,
it does not seem to be possible to relax these assumptions without a considerably more
complex model. However, we are able to reach some general conclusions about the impact
of the assumptions on CDS valuations.

http://www.rotman.utoronto.ca/~hull/DownloadablePublications/CredDefSw1.pdf

So is this saying the model for credit default swap has nothing in that model for a counterparty risk? That model is what financial people use, and it only will work if the counterparty does not default?
If that is what they are saying, then a black swan is not what happened to the financial world.

Finally someone who understands this because neither Taleb nor the majority of the posters here understand it. What happened was not a pricing issue but a counterparty issue. Counterparty default is not accounted for in pricing, that would be silly. It is like ES prices changing depending on who buys or sells a contract. If there is possibility of counterparty default you simply do not trade unless they post sufficient margin, and this is exactly what the organized exchanges manage.

The problem with the crisis was that these OTC counterparty agrreements were not monitored by a central exchange or Bank. It was not CAPM, or anything related to that thatTaleb and others, usually cranks, think it did the damage.

 

[trendlover]

Quote from intradaybill:

Finally someone who understands this because neither Taleb nor the majority of the posters here understand it. What happened was not a pricing issue but a counterparty issue. Counterparty default is not accounted for in pricing, that would be silly. It is like ES prices changing depending on who buys or sells a contract. If there is possibility of counterparty default you simply do not trade unless they post sufficient margin, and this is exactly what the organized exchanges manage.

The problem with the crisis was that these OTC counterparty agrreements were not monitored by a central exchange or Bank. It was not CAPM, or anything related to that thatTaleb and others, usually cranks, think it did the damage.

So they make a big bet with NO enough money to pay that bet if they lose. (No margin call) Because they think they pass a risk, or dilute a risk with swaps for swaps for swaps?

 

[Chart_Precocity]

Quote from sosueme:

Ahhhhh a thinking man, the only basis for the creation of a great Trader.

sosueme

Nailed and exhailed.
Understand your post will be ignored by most.
Nicely stated.

 

[intradaybill]

Quote from trendlover:

So they make a big bet with NO enough money to pay that bet if they lose. (No margin call) Because they think they pass a risk, or dilute a risk with swaps for swaps for swaps?

Ponzi scheme. Nothing to do with CAPM or anything related. Taleb was fooled by ignorance.

 

[Chart_Precocity]

Quote from dtrader98:

Much of the problems stem not so much from mathematics and the precision it enables, rather, the problems are due to lack of observable variables input to the system being modeled. 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.

Anyways, it is similar to physics, in that if you have a closed system and are given all of the external variables that influence that system's state, you can clearly define some model to predict the output of the system (kind of like Laplace's demon, for anyone who's interested). The key is "knowing" all of the input variables, i.e. having them be observable and extractable. The reality is no one knows all of the input variables; some know more than others. Therein, I believe lies the fly in the ointment to your type of discussion regarding predictability of human nature. On a large scale, unless you are privileged to observable precise information regarding the 'cause', your estimation of the 'effect' will be contaminated by noise. Thus, we refer to simpler and more general models to try to extract some of the true signal that is drowning in a sea of noise.

This is also the basis for much of AI. Regarding the earlier poster, in some areas, AI has easily exceeded many professional experts in classification type problems. Something many would be wise to think about. Of course, the biggest problem I have encountered, is not so much the I/O and mathematical processing, but finding and selecting the variables and relationships which are useful to process (and there are a myriad to choose from). I.e. a major challenge in trading is simply explicitly defining the problem to be solved, which is perhaps, more difficult than actually solving it.

Regarding fat tails, they can be modeled and dealt with; hint: excessive leverage is not the key, unless you are implicitly guaranteed bailout, which is likely not the case for us less connected traders. But just because gaussian models are not an accurate representation, does not mean they should be thrown away. Fundamentals and classical knowledge should always come first; then be built upon.

2c

Damn impressive thread.

You can not know all of the variables that effect your trading environment so what is the solution?
Think about how you can control the variables in your trading/charting environment or how you view your trading environment. Someone here turned me on to constant volume bar charting a few years ago and it has made a huge difference in my consistent profitabillity. It was like I had suddenly been able to calm any chart I applied them to.

 

[nelsanity]

Quote from Martinghoul:

Wait a sec, but that's exactly the charge that NNT levels at the academics? Are you now accusing him of doing the exact thing that is so anathema to him?

It just irks me when people say that market movements are random, as nothing could be further from the truth.

And for people to assume CP risk isn't handled is also ludicrous. What do you think collateral management departments do all day long...play solitaire? Just because some dumb funds treated this operations task as of little account doesn't mean other firms are dumb. If the counterparty doesn't post collateral when M2M moves against them or they are downgraded then it's simple...unwind or novate the contract.

Not to mention if an institution wants to enter position A with X notional, they split up the order and put it on with many firms to diversify.

Risk management and collateral management aren't unique to Finance, If you have a vendor or a customer who are in danger of not delivering you always have the option to take your business elsewhere.