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Monday February 5, 2007 - 13:04:17 GMT
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Risk we can't quantify...

Key News
• Key Reports Due (WSJ):
10:00a.m. Jan ISM Non-Manufacturing Business Index. Expected: 57.0. Previous: 56.7.


"As far as the laws of mathematics refer to reality, they are not certain, as far as they are certain, they do not refer to reality."

Albert Einstein

FX Trading – Risk we can’t quantify…

We know volatility has been unusually low across global financial markets—especially currencies. We know there “seems” to be plenty of liquidity. And we know there are huge amounts of leverage being used to exploit low volatility in world with “seemingly” plenty of money.

We use the word “seem” for a reason when we talk about liquidity. For if asset values were to decline abruptly for any of a whole host of reasons we can’t predict, there will be a rush for the exits as collateral (or underlying equity) melts fast when leverage is employed—let’s call it a compressed liquidity crunch.

Our view on the yen is a view about risk. Sooner or later risk, which is both unknown and unquantifiable, will be priced back into this world of global markets. And when it does, the 1$ trillion behind the yen as a funding currency, and the interwoven counterparties on both sides of the trade, will rush for cover. That will move the yen higher.

Some say things are just fine. Stop all this worry wart stuff. Derivatives are to be praised for spreading risk and reducing volatility. And their spread, which is nothing less than a revolution in global finance, insures us the future will resemble the recent past.

Thus, there is no need to worry about a major debacle in the hedge world. They have their derivatives and leverage under control. After all they do “stress testing.” But it’s silly to believe you can account for risk theoretically when you don’t know them and you can’t quantify them even if you did.

“’Fools ignore complexity,’ said Alan Perlis, the US computer scientist, ‘Pragmatists suffer it. Some can avoid it. Geniuses remove it.’ The world's central bankers, who are fretting about the growing complexity of financial markets, are clearly not fools. But unless a genius comes along with a solution, they will have to be pragmatic about complexity, and all of the risks that it entails.”

Financial Times

“In real life, you do not know the odds, you need to discover them, and the sources of uncertainty are not defined. Economists who do not consider that what was discovered by noneconomists as knowledge draw an artificial distinction between Knightian risks (which you can compute) and Knightian uncertainty (which you cannot compute), after one Frank Knight who rediscovered the notion of unknown uncertainty and did a lot of thinking but perhaps never took risks, or perhaps lived in the vicinity of a casino. Had he taken economic or financial risks he would have realized that these ‘computable’ risks are largely absent from real life! They are mostly laboratory contraptions!

“Those who spend much time with their noses glued to maps will tend to mistake the map for the territory. Go buy a recent history of probability and probabilistic thinking: you will be showered with a names of alleged “probability thinkers”, all based on these sterilized constructs. I recently looked at what college students are taught under the subject of “chance”, and came out horrified: they were brainwashed with this ludic fallacy and the outlandish Bell Curve. The same applies to people doing a PhD in the field called probability theory. Furthermore, assuming chance had anything to do with mathematics, what little mathematization we can do in the real world does not assume the mild randomness represented by the Bell-Curve (i.e. the Gaussian ), rather the scalable wild randomness. What can be mathematized is not usually Gaussian, but Mandelbrotian.”

Nasim Taleb, The Ludic Fallacy, or the Uncertainty of the Nerd

Jack Crooks


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