http://www.investorsinsight.com/otb_va_print.aspx?EditionID=601
Introduction
This week in Outside the Box, good friend and London business partner Niels C. Jensen further expands upon the fat tail dilemma I recently discussed in my "Black Swan" e-letter and why many of the risk metrics we use while in theory are useful, in application are woefully misleading. Niels does an excellent job of making the topic understandable and enjoyable to read.
Academic work in the past sixty years from the likes of James Tobin, William F. Sharpe, Eugene Fama, Black, Scholes, Merton, built upon modern portfolio theory and risk management introduced by Harry Markowitz in his now famous paper 'Portfolio Selection,' in the Journal of Finance. Central to all the aforementioned academic work is the assumption that returns are normally distributed, in a Gaussian or bell-shaped curve. If returns are not, then risk management tools such as value-at-risk, become meaningless at precisely the time when you most need risk measurement tools to work! The crux of the matter is a great many finance practitioners today assess investment risk in such fashion, oblivious to the assumptions, and thus, the models shortcomings. The solution you might ask? Niles suggest that it likely lies in Power Law Distributions.
John Mauldin, Editor
Outside the Box
Wagging the Fat Tail
By Niels C. Jensen
The Absolute Return Letter
October 2007
The Old Lady barks
As far as intellectual honesty is concerned, statements do not come much bigger, in particular when aired by a senior member of staff of one of the world's leading central banks. To have the Old Lady of Threadneedle Street openly admitting that not everything that goes on in financial markets every day is entirely comprehensible takes some beating.
The Mansion House speech
Then again, if we take one step back and look more closely at BoE Governor Mervyn King's speech at the Mansion House dinner on the 20th June this year, perhaps we shouldn't be that surprised after all. I suggest you read the next few paragraphs very carefully.
"Securitisation is transforming banking from the traditional model in which banks originate and retain credit risk on their balance sheets into a new model in which credit risk is distributed around a much wider range of investors. As a result, risks are no longer so concentrated in a small number of regulated institutions but are spread across the financial system. That is a positive development because it has reduced the market failure associated with traditional banking.
"But the historical model is only a partial description of banking today. New and ever more complex financial instruments create different risks. Exotic instruments are now issued for which the distribution of returns is considerably more complicated than that on the basic loans underlying them. A standard collateralised debt obligation divides the risk and return of a portfolio of bonds, or credit default swaps, into tranches. But what is known as a CDO-squared instrument invests in tranches of CDOs. It has a distribution of returns which is highly sensitive to small changes in the correlations of underlying returns which we do not understand with any great precision. The risk of the entire return being wiped out can be much greater than on simpler instruments. Higher returns come at the expense of higher risk.
"The development of complex financial instruments and the spate of loan arrangements without traditional covenants suggest another maxim: be cautious about how much you lend, especially when you know rather little about the activities of the borrower. It may say champagne ? AAA ? on the label of an increasing number of structured credit instruments. But by the time investors get to what's left in the bottle, it could taste rather flat. Assessing the effective degree of leverage in an ever-changing financial system is far from straightforward, and the liquidity of the markets in complex instruments, especially in conditions when many players would be trying to reduce the leverage of their portfolios at the same time, is unpredictable. Excessive leverage is the common theme of many financial crises of the past. Are we really so much cleverer than the financiers of the past?"
Cont-
Introduction
This week in Outside the Box, good friend and London business partner Niels C. Jensen further expands upon the fat tail dilemma I recently discussed in my "Black Swan" e-letter and why many of the risk metrics we use while in theory are useful, in application are woefully misleading. Niels does an excellent job of making the topic understandable and enjoyable to read.
Academic work in the past sixty years from the likes of James Tobin, William F. Sharpe, Eugene Fama, Black, Scholes, Merton, built upon modern portfolio theory and risk management introduced by Harry Markowitz in his now famous paper 'Portfolio Selection,' in the Journal of Finance. Central to all the aforementioned academic work is the assumption that returns are normally distributed, in a Gaussian or bell-shaped curve. If returns are not, then risk management tools such as value-at-risk, become meaningless at precisely the time when you most need risk measurement tools to work! The crux of the matter is a great many finance practitioners today assess investment risk in such fashion, oblivious to the assumptions, and thus, the models shortcomings. The solution you might ask? Niles suggest that it likely lies in Power Law Distributions.
John Mauldin, Editor
Outside the Box
Wagging the Fat Tail
By Niels C. Jensen
The Absolute Return Letter
October 2007
The Old Lady barks
As far as intellectual honesty is concerned, statements do not come much bigger, in particular when aired by a senior member of staff of one of the world's leading central banks. To have the Old Lady of Threadneedle Street openly admitting that not everything that goes on in financial markets every day is entirely comprehensible takes some beating.
The Mansion House speech
Then again, if we take one step back and look more closely at BoE Governor Mervyn King's speech at the Mansion House dinner on the 20th June this year, perhaps we shouldn't be that surprised after all. I suggest you read the next few paragraphs very carefully.
"Securitisation is transforming banking from the traditional model in which banks originate and retain credit risk on their balance sheets into a new model in which credit risk is distributed around a much wider range of investors. As a result, risks are no longer so concentrated in a small number of regulated institutions but are spread across the financial system. That is a positive development because it has reduced the market failure associated with traditional banking.
"But the historical model is only a partial description of banking today. New and ever more complex financial instruments create different risks. Exotic instruments are now issued for which the distribution of returns is considerably more complicated than that on the basic loans underlying them. A standard collateralised debt obligation divides the risk and return of a portfolio of bonds, or credit default swaps, into tranches. But what is known as a CDO-squared instrument invests in tranches of CDOs. It has a distribution of returns which is highly sensitive to small changes in the correlations of underlying returns which we do not understand with any great precision. The risk of the entire return being wiped out can be much greater than on simpler instruments. Higher returns come at the expense of higher risk.
"The development of complex financial instruments and the spate of loan arrangements without traditional covenants suggest another maxim: be cautious about how much you lend, especially when you know rather little about the activities of the borrower. It may say champagne ? AAA ? on the label of an increasing number of structured credit instruments. But by the time investors get to what's left in the bottle, it could taste rather flat. Assessing the effective degree of leverage in an ever-changing financial system is far from straightforward, and the liquidity of the markets in complex instruments, especially in conditions when many players would be trying to reduce the leverage of their portfolios at the same time, is unpredictable. Excessive leverage is the common theme of many financial crises of the past. Are we really so much cleverer than the financiers of the past?"
Cont-