What a little volatility can do to your balance sheet
Since I've become something of a volatility junky, let me point you to this interesting FT article that describes how volatility is wreaking havoc on the way financial firms value their assets. An excerpt:
The second, more tangible implication of the return of volatility relates to the models that banks and hedge funds use to measure their assets. When banks extend credit to hedge funds, they often use so-called “value at risk” models (VAR) to measure the risks attached to such loans. These models typically assess the riskiness of an asset by measuring how its market price has moved in the past.
During the Great Moderation, this approach cast a fabulously flattering light on the investment world, creating the impression that it was safe for banks to extend massive volumes of credit to hedge funds. Moreover, since banks typically use VAR to measure the risk attached to their own assets too, these models also seduced banks into feeling complacent about their own risks.
Now, this process has gone violently into reverse: as volatility surges, VAR models are showing that the risk attached to almost any transaction has exploded upwards. Thus banks are selling assets and slashing loans to the funds – in turn sparking more fire sales and increasing volatility in all asset classes. It is a vicious trap that does much to explain why the market upheavals have infected so many asset classes, ranging from subprime to sterling to Shanghai shares.
I've been feverishly working on a magazine piece about risk, and yesterday I happened to have a conversation about the VAR models that were used to value mortgage-related structured products. The guys I was talking to kept saying that a big problem was that VAR models used during an asset boom make the future seem extra-rosy since the model extrapolates from that historical data. I asked why firms didn't use more historical data, maybe going back 30 years instead of--what?--ten years?
Um, no. Try two or three. So we were deriving values for things like CDOs from just a few years of historical data. It's not that the VAR models captured the boom—it's that they only captured the boom. Brilliant. And then plenty of firms either weren't stress testing those models, or they were, and deciding to ignore the results. But more about that in a week or so.
Barbara!
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1
Time for everyone to read The Black Swan again.
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2
hehe - this is what happens when everyone says 'It's different this time!!!!'
next time they should try adding salt or oregano instead of volatility
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3
"Um, no. Try two or three. So we were deriving values for things like CDOs from just a few years of historical data. It's not that the VAR models captured the boom—it's that they only captured the boom. Brilliant. And then plenty of firms either weren't stress testing those models, or they were, and deciding to ignore the results."
That doesn't sound like a Black Swan to me. That sounds like a garden variety white swan that is being desperately doused in ink to pass off as a black swan.
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4
@pneogy: Amen to that.
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5
Using two or three years of data was done intentionally. Leveraging to the limit was the goal. Taking risk with other people's money was the goal. Win and you - personally - win big. Lose, so what?
That's the problem when people look out for themselves and lack integrity.
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6
This is what happens when someone orders you to start with the desired solution and then go workout the necessary formula. Does anyone believe that the Lords of the street sleep at night because of the VAR numbers?
KING OF GREEK MODE
(King of the Road)
WilliamBanzai7Traders who just invent
Rules without common sense.
No phones, or blind fool bets
I ain't got no trading sense
Ah, but..two hours of crunchin in the data room
Buys an eight million dollar four bedroom
I'm a man of means by standard means
King of Greek Mode.Black box, midnight brain
Innovative trades, just insane.
Old worn out suits and shoes,
Don't pay no heed to world news,
I smoke Cuban stogies and make garbled sounds
Short sell, but not too much all around
I'm a man of standard means by no means
King of Greek Mode.I know every trading engineer from here to Mumbay
All of their children, and all of their names
And every printout in every town
And every black box that ain't locked
When no one's around.I sing,
Traders who just invent
Rules easy to circumvent
No phone, or blind fool bets
I ain't got no trading sense
Ah, but, two hours of crunchin the data room
Buys an eight million dollar four bedroom
I'm a man of means by standard means
King of Greek Mode. -
7
Barbara, I think you will enjoy this Article by Satyajit Das:
http://www.wilmott.com/blogs/satyajitdas/enclosures/perfectstorms(may2007)1.pdf -
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8
Sorry: Here is the Das link:
WilliamBanzai7
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9
@pneogy/Justin: Nassim Taleb agrees with you:
http://www.time.com/time/business/article/0,8599,1853531,00.html
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