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Wednesday May 24, 2006 - 09:51:19 GMT
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Risk, Volatility, and Circular Reasoning


“Circulatity of Statistics (The Statistical Regress Argument): We need data to discover a probability distribution. How do we know if we have enough data? From the probability distribution. If it is a Gaussian, then a few points will suffice. How do you know it is a Gaussian? from the data. So we need the data to tell us what is the probability distribution, and a probability distribution to tell us how much data we need. This causes a severe regress argument.”

Nassim Taleb

FX Trading – Risk, Volatility, and Circular Reasoning

The danger is in the outliers…

“The previous point deals with how the 90% range around trend narrows because of mean reversion. However, the extreme 10% this analysis misses is particularly important. For 90 or 95 percent of the time, all you have to do is show up for work and keep your nose clean. It doesn’t really matter what you do since assets are reasonably priced relative to their risk and each other. But once or twice in a career there are major aberrations and it absolutely matters what you do. It is the time to use some of your career risk units and try to make a difference.
Mandelbrot has weighed in on this point with his book The (Mis)Behavior of Markets, which contains one of my favorite quotes: ‘”Economics … has not truly come to grips with the main difficulty, which is the inordinate practical importance of a few extreme events.’

“…But the real action is with the outliers. 1987 was an 18-sigma event; the sun would have to cool down completely before you would expect to see one of those based randomly on the distribution of the other 99.9% of all days. These outliers have enormous implications for decisions such as leveraging and selling options. You take home a nice profit year after year, and over 10 years it can look ‘riskless,’ and then, bang – you’re dead. Some hedge funds have an element of this selling insurance imbedded in them, so caveat emptor.”

Jeremy Grantham

Source: GMO Quarterly Letter, April 2006

Gold Weekly: $550 represents a standard retrace from the 1999 low in gold…

There is always more danger lingering in markets than we care to admit. We all fall in love with our stories. We can dress them up in either qualitative or quantitative garb, they are still stories.
This tidbit was sent to us yesterday from a friend in New York; it is a research comment from Goldman Sachs. It talks about the volatility we have seen and makes some interesting points. But our favorite part is at the end…

“2. Value at Risk or Volatility Agitated Returns?

“When investors capitulate in trades that they still like fundamentally, without any specific news to change their preferences, other forces are usually at work. In this context it seems useful to discuss the influence of widely used risk management tools, such as ‘Value at Risk’.

“Using volatility and correlation measures, these models are used to calculate the estimated distribution of daily returns of a given portfolio of investments. On the basis of this distribution, risk managers can calculate the expected size of a loss at a given level of probability. For example a 99% VAR of $1000, implies that the daily loss of a portfolio is expected to be equal or larger than $1000 only once in 100 days.

“Critically for this and similar models, historic volatility and correlation patterns are supposed to hold in the future. Obviously this has not been true recently. To give an example, 1-month historic volatility in $/TRY has increased from 5.4% at the beginning of May to 28.5% currently. Turkey may be an extreme case, but even crosses like EUR/PLN have seen historic volatility double from about 6% to almost 12%. While implied volatilities have not moved as much they have still increased substantially.

“Correlations across and within many asset classes have also increased recently, but metals markets are probably the most extreme cases. The return correlation of gold and copper, for example, has increased from 10-30% at the beginning of the month to more than 60% currently.

“When the volatility of returns becomes larger than one would have expected, the urge to reduce risk may become large and considerations such as carry or other fundamentals may become secondary.

“While these mechanics could theoretically result in circular waves of rising volatility/correlation and risk reduction, it is important to point out that every experienced risk manager is aware of the potential shortcomings of the VaR or related models. Past volatility is a less than perfect guide for future volatility. In fact, as we have been pointing out in our research, there have been signs of potentially rising volatility for a while.

“Interestingly, the very fact that even the Brazilian Real has now been touched by the wave of risk reduction could herald the end of these circular dynamics. We are therefore cautiously optimistic that short dated volatility should decrease from currently elevated post-unwinding levels.”

We’re thinking, after reading this: Why are they “cautiously optimistic short dated volatility should decrease”?

It seems we live in a world of circular reasoning when it comes to financial market risk. This comment from Goldman goes directly to the point that Nassim Taleb makes in the Quotable above this morning.

A look at the $-Brazilian Real chart alone suggests to us there could be plenty more risk and potential volatility out there in emerging market land…

Two questions: Do you think this so-called global risk reduction is over? And if not, which currency benefits the most if a “real” run for cover ensues?

Jack Crooks, Black Swan Capital
Black Swan Subscription-based Service


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