http://www.wilmott.com/blogs/PabloTriana/index.cfm en-us Wed, 22 May 2013 18:49:50 --0100 Sat, 21 May 2011 16:49:00 --0100 BlogCFC http://blogs.law.harvard.edu/tech/rss blogs@wilmott.com blogs@wilmott.com http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/5/21/Models-On-Models It seems clear that one of the big reasons why finance theoreticians may resist and despise the criticisms of finance theory (even the calls to ban finance theory as deleterious to the world´s health) is that a theory-less universe would deprive them of the capacity to model. If modeling is possibly useless and potentially dangerous, do we need modelers at all? I have a solution for the understandable angst that some modelers may feel these days, faced more than ever with external scepticism and cynicism as to their contributions. Why not model about the limits and dangers of modeling? Rather than spent yet more time dealing with some technical minutiae of existing models, why not build a model analyzing the impact on markets and the economy of existing models? So no more papers on, say, VaR. Rather, papers on how VaR´s presence in financeland poses risks for the world. Make it as mathematical as you want. No more models, rather more models on the dangers of models. Miscellaneous Sat, 21 May 2011 16:49:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/5/21/Models-On-Models http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/4/28/Books-And-Books The books I like to read may not always be the books I like to write. I like to read Michael Lewis but I am not sure I would like to write those type of books. It´s great to read story-telling, but perhaps not so great to write story-telling. There´s no philosophy, no critique, no praise, no recommendations, no idealism in plain story-telling. I mean Liars´Poker and The Big Short are great masterpieces but all they do is entertain. They don´t provoke too much thought, they don´t aspire to stir the pot, to change things, or to keep them as they are. They don´t have a viewpoint, they don´t make you want to join a battle. They don´t impact the world (nor do they seem to want to). No one gets angry (bar perhaps Salomon´s bigwigs and that Wing Chao guy who´s suing ML) after reading those tomes. No one gets elated. No one gets excited. No one gets moved. No one is inspired. There are no calls for revolution or for counter-revolution. The status quo is neither lambasted nor defended. It´s all very plain vanilla. In a very pleasant way, but no tutti frutti. That´s not to say I wouldn´t love to do a story-bio kind of book (or that I wouldn´t kill to have ML´s talents), but in that case I would try very hard to be normative as well as positive. Not mere describing, a bit of extra meat too. Some stirring of the pot. More Niall Fergusonish or Paul Kennedyish. There´s got to be some profound conclusion, even if the rest of the book is just narrating things that happened. A look towards the future, too. A book that creates loyal friends and terrible foes. Having said all this, the written English I´ve enjoyed most to this day is ML´s collections of uber-descriptive essays assembled under "The Money Culture". Books Thu, 28 Apr 2011 15:34:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/4/28/Books-And-Books http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/4/5/Derman-and-I I notice that Emanuel Derman is about to release his new book. The tome seems to deal with how the failings of finance theory can impact the world. This sounds very close to what my Lecturing Birds attempted to do. There are big differences though. For one, Derman knows much more than I do about the subject matter. He is also a better writer. But I suspect that there is an area where I may have a slight comparative advantage. I am an amateur, a dilettante, a stranger in a strange land. Derman is a pro in the field. While he is way more open and honest than most other pros in this debate, he may not want to be more open and honest than necessary. In other words, he probably can´t or doesn´t want to be a denunciator. He can´t or doesn´t want to be too critical or too cynical. I, on the other hand, was able to be stringently accusatorial because I had no allegiance but to the evidence I unearthed and what such findings dictated me to conclude. Derman can highlight VaR´s weaknesses but he might not want to call for its banning. Derman can talk about BSM´s flaws, but he might not want to embrace Taleb-Haug. Derman can denounce the unrealism of models but he might not want to lead a campaign against the (possibly impractical, probably lethal) modelling of finance. So I eagerly await the release of Derman´s new pearl. I have no doubt that it will make for brilliant and enlightened reading. But I don´t expect to find any calls for revolution. I don´t expect any statement a la "models can be so demonstrably dangerous that we should actively protect the world from them". And that, in a way, is a pity. For Derman can garner many more followers than my humble Lecturing Birds ever could. He, as an elite member of the practising and teaching quant community, could be the messiah that parts the waters and leads the many towards a paradise land where implacably destructive mathematical trickeries don´t wreak untold economic and social havoc. Books Tue, 05 Apr 2011 11:47:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/4/5/Derman-and-I http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/3/24/Academic-Leap I have been reading some very good academic papers on whether equity capital is really more expensive than debt financing, and thus whether we should be really concerned by banks being demanded to alter their equity-debt mix by reducing leverage. Some financiers say that ehanced equity requirements will sink the economy, as the cost and availabity of credit would become less socially friendly. Bollocks, say the professors (from top unis). The myth that equity is more expensive is just that, a myth. No bank should have to push loan costs up or reduce lending as a result of tougher capital regulation. And Basel III, publicly portrayed as the proper medicine to the disease of excessive leverage, is not even enough. I have been surprised by the profs´candor and their brave contrarianism. In one fell swoop, they manage to go at both the regulators and the bankers. But I wonder if they realize the implications that their arguments have in terms of the use of models in finance. Naturally, for the past fifteen years capital requirements have been based on models. These models, not surprisingly, have enabled unlimited leverage and have allowed banks to trot along equity-free. So an argument for equity should automatically imply an argument against said models. And an argument against said models should imply at the very least a very serious rethinking of the overall role of models in finance. Among other things, because the models used for regulatory capital include some of the ideologies and tools held most sacrosanctly by theoreticians. If those models fail (because they inexcusably sanction too little equity) then those ideologies and tools failed. If those failed, what does that say about the discipline of finance theory? Shuldn´t these profs take the leap from "more equity is good net net, leverage is bad net net" into "theoretical finance has failed us much too much, let´s rethink how we teach and what we publish"? I understand that that may be a contrarian bridge too far (given that the fellow in the university office next door may have devoted an entire career to those failed models, for instance), but it would nonetheless be a very positive development not just in the aid for truth but also from a social point of view (it is obvious to these academics that bank leverage is a horrible horrible thing that causes untold mayhem, so fighting tools that abet the monster should be a good deed, right?). I have humbly made that leap several times (read chapter 5 in my Lecturing Birds On Flying, or any of my FT articles on the subject, or my recent Yale Economic Review piece). Wouldn´t it be nice if uber-prestigious tenured ivy-leaguers would too choose to leap forward? VaR Thu, 24 Mar 2011 19:33:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/3/24/Academic-Leap http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/3/16/Basel-VaR-and-Me Haven´t you noticed how bank regulators have of late taken to badmouthing VaR and fingerpointing it for its role in the crisis? I know, I know, this typically goes uncovered by the media. But for all of us VaR junkies (and I have become one since fully realizing VaR´s responsibility for the catastrophe), it is quite something to witness the BIS, the Basel Committee, the UK FSA, and others basically shout from their rooftops that VaR is and always was crap that would eventually and inevitably lead to perilously lethal toxic leverage in the banking industry. I know, I know. The mandarins have not gone so far as erasing VaR from the land, but they seem like they would really like to. All those tweakings to Basel´s calculation of the market risk capital charge (a public recognition that the prior system, aka just VaR, was rotten to the core) aim at achieving a VaR-lite regime. It is obvious to me that the add-ons may not solve much, but that´s another issue. What truly matters is the regulatory message: we messed up by embracing VaR all these years, can we make amends? This must be taxing times for hard-core VaRistas in the risk management and academic worlds. Even their hitherto public-sector allies are jumping ship. What must be even worse for some (like those who lambast my musings with ad hominen attacks, never by addressing the issues) is that quite important regulators now quote from my Lecturing Birds On Flying when looking for supporting arguments in their current "VaR failed" campaign. Some very powerful folks in Basel seem to be saying that that Triana guy actually got something quite right! Any VaRista out there feeling a bit queasy after reading all this is welcomed to retaliate by posting on the web yet another critique of my book on the grounds that "the style is convoluted" or "the author is unbearably repetitive". Anything but countering the book´s arguments. Especially after even the regulators don´t want to be seen in VaR´s company. VaR Wed, 16 Mar 2011 22:17:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/3/16/Basel-VaR-and-Me http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/2/2/Why-I-Wrote-Lecturing-Birds-On-Flying One ?Peter? has, in a popular quanty site, posted less than amicable comments about my persona and my humble musings. I don´t know who Peter is. I know that there are several well-known quants whose names begin with Peter. Maybe one of those Peters is ?Peter?, I am not sure. Let me try to offer an adult response to ?Peter?´s rather infantile rants. First of all, and as ?Peter? aptly emphasizes, I am a stranger in a strange land. I am a non-quant non-theoretician who´s infiltrated the mathematical finance sphere for the past three years, via my Lecturing Birds On Flying and several models-doubting articles. I have never produced a mathematical paper or taught a math-heavy course. My direct experience with the quanty universe is limited to my student days, to my days as a derivatives marketer, and to the brief period when I dated a New York girl who had just dated a (rich) quant. I am not a quant, and have never pretended otherwise. In fact, I thank ?Peter? for reproducing those parts of my book where proper disclaimers can be found. The key issue, then, becomes: can a non-quant non-theoretician write a book dealing with finance theory and quantitative finance? Sure, why not? Many great tomes have been authored by people without direct membership in the world that´s being described. The best books on LTCM were penned by a general journalist with no markets experience, and by a financial journalist with no markets experience (but, granted, high-level science background); and those were wonderful efforts. Michael Lewis has written fantastic books dealing with fields as alien to his professional background as football, baseball, politics, the internet, and Subprime CDOs. Non-academic journalists John Cassidy and Justin Fox have compiled good chapter after good chapter on the history of financial economics. Peterson from the WSJ wrote ?The Quants?, even though I have a feeling he couldn´t personally be further away from quantyland. Someone has recently produced a bestselling bio of Cleopatra, even without being Egyptian, having ever met the lascivious vixen, or having ever participated in the construction of a pyramid. Compared to those efforts, Lecturing Birds could almost be accused of having been written by an uber expert. Again, I spent several years studying the tools (I got an A in stochastic calculus!), I read some of the key textbooks (Musiela, Shreve´s class notes, Neftci, Wilmott), I read Risk magazine, I read (and almost understood) Taleb´s Dynamic Hedging, I read Derman´s My Life As A Quant, I built an exotic options calculator that was used by NYU students, I have taught advanced derivatives at top international schools, I have published in Risk, I have published with Risk Books and Wiley, I read Fisher Black´s Biography, I read Capital Ideas, I have met some of the world´s top financial economists and mathematicians, I have sold exotic derivatives, I have professionally interacted with top-bank quants, I have read tons of research papers, and, last but not least, I´ve been fortunate to have dinner with leading theory-agnostics Nassim Taleb and Espen Haug. In other words, this non-quant had quite a lot of ammunition at his disposal to write a book subtitled ?Can Mathematical Theories Destroy The Financial Markets??, plus his intellect was sizable enough to pick up new stuff as things evolved (Gaussian Copula stuff, VaR stuff). In any case, what I am trying to say is that you don´t need to have had first-hand direct experience in a field to successfully muse about happenstances pertaining to that field, provided that you are resourceful and intelligent enough to find good sources and to learn on your own. Bestselling authors do it, and have done it, all the time. Did that guy Chernow ever ride with George Washington? Certainly not. Does that diminish the value of his work? Certainly not. Should we doubt his conclusions because of that? Certainly not. What you should do is make clear from the get-go what your possible limitations may be, and that I do in spades in Lecturing Birds, as ?Peter? so graciously remains us. If I am not a bona fide citizen of quanty land, why then did I sacrifice my time for this endeavor? Because the topic was too relevant to ignore, too influential to abandon. Once it became clear that flawed, yet widely popular, models had contributed to the 2007 crisis there was no option but to spread the word. Just like there was no option but to try to summon the world into seriously considering the proper role (if any) of quantitative finance models going forward. Lecturing Birds was aiming at a serious, adult, responsible audience that, even if perhaps in profound disagreement with my dictums, would rise to the occasion and focus on the unavoidably serious themes under consideration. I am pleased to say that some top quantitative priests did regale us with value-adding commentary, gentleman scholars like Steven Shreve and Aaron Brown who are more than capable of rebutting an argument without recourse to cheap, unintellectual, childish ad hominism. But ?Peter? (like many others who´ve displayed similar behavior towards the book) doesn´t seem to have the same gravitas, appearing as a much smaller figure than those two giants. The stakes are too high to waste our time with tired and empty ramblings. This was supposed to be a debate for grown-ups. Books Wed, 02 Feb 2011 23:29:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/2/2/Why-I-Wrote-Lecturing-Birds-On-Flying http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/1/12/The-ShreveTriana-Debate Courtesy of QuantNet Steve Shreve on Pablo Triana?s The Flawed Math of Financial Models Editor?s note: Following Prof. Shreve?s article, we received a response from Mr. Triana on Jan 10 which we have published in full. It can be seen directly after Prof. Shreve?s article. By STEVE SHREVE In his article ?The flawed math of financial models?, Financial Times, November 29, Pablo Triana seeks to fix a large portion of blame for the world-wide financial crisis on ?quants? in the finance industry and the programs that educate them. Mr. Pablo recommends radical reform in such programs. Others, carrying these ideas farther, call for a diminished role for quants in finance. Any discussion of quants in finance must begin with the recognition that the global integration of economies and the associated complexity of our financial system has made the use of mathematical models an indispensable tool. Rules-of-thumb and intuition will not suffice when multi-national firms face exchange rate risk, funding risk and commodity price risk, when insurance companies and pension funds face longevity risk, when financial institutions are called upon to mediate these risks, and when regulators are charged to oversee these institutions. This was recognized in the recent U.S. financial reform legislation, which authorized a government Office of Financial Research whose task in 2008 would have been to alert policy makers to the ridiculously large naked position in credit default swaps held by AIG and to predict the effect of the failure of Lehman Brothers. Such an office must necessarily be populated by quants, people who can build models into which information about financial institutions is fed. What then is the appropriate training for quants? I believe we should focus on three aspects. Most importantly, a quant must be competent in the technical disciplines of mathematics, statistics and computer programming, and she must be knowledgeable about financial markets. Achieving competence across this broad spectrum is a tall order. But it must be done because a well-intentioned incompetent quant is as dangerous to the financial system as a well-intentioned incompetent doctor is to personal health. The primary focus of the educational programs at Carnegie Mellon will remain the creation of competent graduates. This is what we do best. But a good quant also needs good judgment. A wise quant takes to heart Albert Einstein?s words, ?As far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality.? All models are wrong. Judgment is needed to know when an admittedly wrong model can be helpful and when it is dangerous. This kind of judgment is acquired primarily through experience, but we can begin teaching it in the classroom. Since the financial crisis, we have invited participants in the crisis to speak in detail to our students about deals that went bad, describing how the deal was analyzed, why it was approved, and what was overlooked. Finally, we need people with integrity managing our financial systems. Teaching ethics is difficult, and guaranteeing that listeners will implement those teachings is impossible. It is not easy for a quant to sound the alarm that his models are being stretched beyond their limits, knowing that if he is taken seriously it will result in the loss of business to competing firms and may result in the loss of his job. We cannot instill in sixteen short months behavior that properly requires years of nurturing and mentoring. We do what we can, leading by example, penalizing students for academic dishonesty, setting and enforcing rules for ethical conduct when interacting with potential employers, posing ethical dilemmas for classroom discussion, and encouraging our graduates to consult with fellow graduates when facing tough ethical decisions. A lesson that can be learned from the present crisis is that if everyone implements the same good idea, their collective action can invalidate the assumptions that made the idea good. If everyone assumes that U.S. housing prices cannot decline and makes large bets based on that assumption, their collective action will ultimately bring about a decline in housing prices. This is not a new lesson; it is the lesson of every bubble. A feature of the most recent bubble is that quantitative analysis contributed to a false sense of security that encouraged firms to scale up risks. In some cases senior managers and even quants themselves did not appreciate the limitations in the models on which they based their risk analysis. Our students do not begin their careers at the level where the disastrous decisions were taken, and only a handful of them will ever reach those positions of power. Nonetheless, in the short time they are in our care, we seek to the extent possible to make them competent quants who exercise sound ethical judgment. About the Author Steve Shreve?s books The Binomial Asset Pricing Model and Continuous-Time Models are the required textbooks for many MFE programs? Stochastic Calculus courses. He is a professor at Carnegie Mellon University and one of the co-founders of the M.S. in Computational Finance at Carnegie Mellon. -------------------------------------------------------------------------------- The following is a response by Mr. Triana sent to Quantnet on Jan 10, 2010. By PABLO TRIANA Let me first say that I deeply admire Professor Shreve. Though my mathematical background does not empower me to fully appreciate his scientific prowess (not that his unparalleled global reputation would ever necessitate my feedback as further support), I am aware that in replying to his analysis of my recent FT article on quant education I am addressing most possibly the world´s leading light when it comes to stochastic calculus and mathematical finance. And far from an aloof researcher, Professor Shreve is also a very successful and ingenius academic entrepreneur, having taken a leading role in the development and management of one of the most exciting and path-breaking university graduate programs ever devised. To top it all, I can personally attest to his human generosity and kindness, getting misty-eyed as I recall the time when Professor Shreve, now about a decade ago, kindly accepted my invitation (as President of NYU Stern´s Financial Engineering Association) to regale us with a wonderful lecture and an even more pleasant follow-up dinner at a fancy Soho restaurant. I vividly recall him being impressed by my thorough knowledge of and interest in his legendary Computational Finance program at Carnegie Mellon, to the point of asking me why I had chosen NYU instead (I didn´t even try to apply to terrifyingly intimidating Carnegie Mellon, acutely aware of my negligible chances at getting in; I ain´t no rocket scientist, folks!). In sum, it is not only my responsibility but also my pleasure to try to address Professor Shreve´s rebuttal as respectfully as possible, given the caliber of the counterparty. I hope I manage to succeed at this, if not so much at triumphing in the debate. Some initial clarifications are in order. I don´t really blame quants and quant programs for the crisis. I blame the use of certain models for the crisis. I don´t really care if those using, peddling, and imposing the deleterious models were quants, traders, salesmen, or fast food caterers. My goal is not to target specific groups of people, my goal is to target specific analytical concoctions. Having said that, it is true that a lot of quants vouch for those models both inside and outside the financial industry and, much more critically, vouch fanatically for the quantification of finance in general. As long as such belief is held and enthusiastically pushed, we can get in trouble because the potential for bad models to infiltrate the markets would be made that much larger. We need to create much more restrictive filters when it comes to welcoming mathematical finance wizardry into the realm of practice. Quants and quant programs could and should have been much less permissive and much more critical. Roadblocks to dangerous models should have been forcefully built by those who best understand the mechanics. So, yes, quants and quant programs could in the end be subjected to one type of accusation: neglect. Everything stated in Professor Shreve´s response makes a ton of sense, and one can´t help but wholeheartedly agree. But, like other famed quants too graced with the ability to muse gracefully and the valour to challenge flawed quanty practices, Professor Shreve does not go far enough. Just like Emanuel Derman, Paul Wilmot, or Ricardo Rebonato, Professor Shreve needs to get closer to Nassim Taleb (and, maybe, my very humble self) and take things a step or two further and engage in a healthy dose of loud name-calling and unabashed denunciation. It is not enough to state that quantitative analysis played a role in the crisis by encouraging misplaced confidence or that many misunderstood the maths. It is imperative to endlessly fingerpoint the main culprits, essentially VaR and Gaussian Copula (to Professor Shreve´s credit, he went after the latter in a recent piece), and to make sure that such utterly failed tools are never again given the keys to the risk kingdom. Demonstrably flawed and lethal models should be banned from the land, and the real reasons for their original embracement intrusively inquired. VaR can no longer be part of banking regulations. These things can´t continue being taught, unless they are presented as the bad that can emerge from the quant lab. More pressing still, those failures must serve as catalyst to force everyone to revisit whether finance can and should indeed by mathematized. Are VaR, Gaussian Copula, Black-Scholes, Portfolio Theory, or Financial Econometrics isolated cases of failure, or rather inescapable proof that financial theory is bound to be at best useless and at worst crisis-igniting? We urgently need a Mathematical Finance Council of Nicaea, so that these pressing questions are answered once and for all. I wrote my Lecturing Birds On Flying in a naively idealistic attempt to help kick-start such process. Will the best that the discipline has to offer, like Professor Shreve, pick up the gauntlet? This is no time for mincing words, it´s time to act. Back in 1994, Carnegie Mellon showed untold innovativeness and courage by correctly embracing the forcefully emerging field of financial engineering. It became the indisputable world beater. Now, with the discipline in tatters and accused of horrible crimes, the same institution should once more display one-of-a-kindness and lead the second quant finance revolution, the one that ought to make sure that models and financial stability can coexist side by side and the one not afraid to terminally castigate those naughty analytical concoctions that wreak havoc. About the Author Pablo Triana is the author of Lecturing Birds On Flying: Can Mathematical Theories Destroy The Financial Markets? (Wiley) Miscellaneous Wed, 12 Jan 2011 18:10:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2011/1/12/The-ShreveTriana-Debate http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/8/5/Donald-Van-Deventers-SelfServing-And-Childish-Critique This is what Donald Van Deventer (apparently one of the godfathers of quantitative risk "management") has to say about my Lecturing Birds On Flying: "This book is the risk management equivalent of someone who says automobiles are useless because a few drivers crashed. The author has absolutely no understanding of risk management in either theory or practice. Don't waste your money" Pretty adult stuff, uh? Is that how far your PhD in Business Economics from Harvard can take you, Don? No need to deal with the issues head on, is there? No need to actually try to rebut my arguments, right? Let´s just take the easy path of cheap ad hominism. Your sophistication is illuminating, Don. Absolutely awe-inspiring. But of course you are an Ivy Leaguer. Actually I am grateful for Don´s ridiculously empty attack. It confirms that which I of course strongly suspected: I AM RIGHT, and my book is right. And that bothers Don and his peers very very much. After all, as Taleb has said many times, their entire business is being threatened. Don´s childish, issues-skirting response tells me that Lecturing Birds has bothered those bent on preserving the quantification of finance without regards to the collateral damages or the actual soundness of the math, and that does not bother me one bit. They don´t want the message being spread out, and that makes me smile. I can actually borrow from Don´s analogy and, boomerangishly, throw it back at him. You see, Don, unlike most (all?) quant finance models, automobiles in fact do provide an unquestionably useful service and thus were an unquestionably relevant and needed innovation; also unlike quant finance, automobiles don´t have a tendency to structurally fail, they actually work pretty well; and, too in sharp contrast with quant finance concoctions, in those occasions when automobiles are shown to be defective they are immediately taken out of circulation, not preserved and ceasessly peddled and promoted. What Don and his peers are proposing is the equivalent of Toyota NOT recalling those deleteriously malfunctioning Lexus, instead keeping them on the road (keeping them harming people) so that the engineers who work on the cars don´t lose their status and paychecks. How´s that for responsible risk management! The quant finance models that I criticize in my book ARE in fact utterly useless because they have a structural, inbred, unavoidable tendency to crash. In fact, they are worse than useless, as they can cause lots of malaise. What kind of individual would promote and peddle useless stuff that can cause trouble, Don? Did you actually read the book, Don? If so, why don´t you step up and confront the real issues, some of which I am happy to list for you below: - BSM is deeply flawed and can cause trouble and has caused a lot of trouble - VaR is deeply flawed and can cause trouble and has caused a lot of trouble - Reliance on Normality, variance, correlation, expected return is deeply flawed and can cause trouble and has caused a lot of trouble - The last three mayor market crisis were all aided, abetted, and caused by the widespread use of flawed quantitative models - Using VaR as the regulatory measure for trading capital charges is a huge mistake that leads to the (hidden) build up of lethal risk trough massive leverage - BSM was given the Nobel for something that doesn´t (can´t) work in real life and that is based on insultingly erroneous assumptions - Flawed models are embraced by otherwise no-nonsense pros as alibis for reckless, otherwise not permitted, behavior; that is, if analysts are oftentimes known as the ?whores of banking?, complicit financial mathematicians would in fact become?well, you fill the blanks - Quantitative risk management has not demonstrably solved any priorly unsolved problem, while creating lots of new, otherwise non-existent, problems Not a single critic of my book and ideas (bar for perhaps the formidable Aaron Brown) has confronted the issues and tried to refute the above points (and many more). Not a single one. And these guys, a la Don, all have PhDs from top unis. And yet, all they seem to be able to do is fire mud at my face, in a decidedly un-Ivy League manner. Didn´t they have debate class at Harvard, Don? Or is it that mad quant finance folk can do only two things, namely draw equations and hurl cheap aspersions? If you read my book you´ll see that one of my intentions (a main intention) was to humbly contribute to the kick-starting of a serious and mature debate on the true merits of quant finance, so that both sides can try to reach a healthy understanding for the sake of the markets? and the economy´s health (not to mention the actual relevance of academic research). Given Don´s and his peers´ infantile reactions, it is obvious that, so far at least, I have not succeeded. Perhaps I made the mistake of assuming that I was talking to adults. Don´s critique of Lecturing Birds adds absolutely nothing to this most important of debates. Alike his friends (all 100% dependent on the quant stuff remaining around in financeland; the banning of the models must be avoided at all costs, lest some people may have to go back to being the lowly college professor at family reunions as opposed to the one who made it to Wall Street), he seems incapable of even defending his own point of view. He can´t even stand up and shout ?VaR is great, the most glorious invention of all times? or ?Quantitative models had nothing to do with the credit crisis?. And that´s because, well, he really can´t. Unless he is willing to lie through his teeth that is. Don is so coarsely rustic that he doesn´t even realize that in my book I don´t dismiss all quantitative finance efforts, but rather point out that there are several demonstrable episodes of horrible malaise caused by certain (rather quite famous) models and that such malfunctioning vehicles should be terminally recalled, and that we should be watchful going forward and ruthlessly terminate any future malfunctioning model, and that that should involve a comprehensive across-the-board no holds barred re-examination of the need for models. Don´s critique is that of a child. Or, as Nassim would put it, that of a half-man. This debate is far too serious to be left to childish whinging. Don´t waste your time on Don. Books Thu, 05 Aug 2010 00:21:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/8/5/Donald-Van-Deventers-SelfServing-And-Childish-Critique http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/7/8/From-JorionTaleb-To-ChoudhryTriana Almost fifteen years after the seminal VaR debate between academic P Jorion and practitioner N Taleb, a much more humble follow-up (courtesy of Financial World mag). VaR not guilty Over-reliance on Value-at-Risk (VaR) and a misunderstanding of its statistical accuracy were mistakes made by bank management in the run-up to the crash. However, to suggest that a mathematical measurement tool, as opposed to, say, incompetent management or poor loan origination standards, was a prime cause of the crash is a gross abrogation of responsibility. Pablo Triana (How VaR put banks on road to ruin, FW May) suffers from the same conceptual misunderstanding of VaR that bankers had, and assigns a bigger role to a statistical model than it deserves. VaR was not ?invented by Wall Street in the late 1980s? ? it was introduced by JPMorgan in 1994. Second, there were two applications for VaR: market VaR and credit VaR. One version used past returns to model the future, but the standard version allowed the user to input the volatility parameter and modify this as it wished. Market VaR is not significantly more inaccurate than modified duration. Triana says VaR treated US Treasuries the same as collateralised debt obligation (CDO) tranches; but it is a simple statistical model and does what it is told. Most credit VaR models use the credit rating transition probability as their main input, so if a CDO tranche is assigned a AAA rating, statistically over the next 12 months it has the same default risk as a US Treasury. Of course, we all know this is nonsense, because a CDO exhibits greater credit risk than a Treasury, so the problem lies not with VaR but the use made of it. Third, and most importantly, Basel rules, not VaR, drive the calculation of bank capital and (indirectly) the level of leverage. Basel 2 allowed regulatory capital to be calculated according to credit rating and, in one version of it, using the bank?s own statistical data. VaR does not impact regulatory capital rules, so blaming it for high leverage of Wall Street banks is unfair, inaccurate and takes the focus away from the real culprits: management. The real problem with VaR, which Triana could have pointed out, was that the most common version (the variance-covariance approach) assumed a lognormal distribution for volatility and was usually calculated at a 90 per cent or 95 per cent confidence interval. Extreme market crashes do not follow a lognormal pattern, and crucially occur with much greater frequency than such a confidence level implies; which is why VaR could never hope to capture severe market corrections. Irresponsibly, senior bank management was frequently unaware of this. Many failed banks, including HBOS, Northern Rock and Bradford & Bingley, did not use credit VaR, at least not exclusively at the expense of other risk measurement methodologies. So their failure must be blamed on something else. Ultimately, one has to look at incompetent bank management. Professor Moorad Choudhry, London Metropolitan Business School VaR in the dock As someone who has been writing financial books for a while, including one on Value at Risk (VaR), I was puzzled by Moorad Choudhry?s letter in the June issue of FW. It misrepresents key aspects of VaR. Contrary to his assertions, VaR was invented in the late 1980s: as has been amply documented by well-known sources, VaR made its formal debut inside JPMorgan around 1989-90, having been conceived and fine-tuned in prior years (in fact, Bankers Trust had developed something similar to VaR even earlier). What happened in 1994, well after the tool had been developed and had begun to be used, is that JPMorgan (through the Riskmetrics conduit) shared its VaR methodology with the world; the main goal of such public release was most likely to entice regulators into embracing VaR as the officially sanctioned risk management and capital-setting tool. VaR is, of course, used for regulatory capital purposes. In 1995, the Basel Committee decided to allow banks to use VaR for the calculation of the market risk capital charge. Such allowance has not been rescinded to this day. In fact, other regulators joined the bandwagon in the meantime, such as the SEC in its devastatingly fateful 2004 ruling that embraced VaR. Choudhry?s comment that ?VaR does not impact capital market rules? is simply without foundation. VaR can, and did, lead to poisonous leverage, courtesy of its monumental design flaws. The central question should thus be: why continue using a flawed tool that leads to crisis? Following the path trodden by VaR-defenders, Choudhry skirts the issue and sheepishly blames traders and bankers for misunderstanding poor old VaR. Such nonsense is typically promoted as a way to preserve the tool (and those who measure it and teach it) within financeland. VaR was used exactly the way it was always intended to be used. Are we really expected to accept that those who 1) created the model in the first place, 2) have internally fine-tuned it for two decades, and 3) have spent years lobbying for its adoption by policy-makers, have forgotten that VaR is based on normality, focusing on the selective past and trusting correlations? What Choudhry fails to appreciate is that those supposedly not-understood characteristics are most likely the very reason why VaR was promoted by banks in the first place. Pablo Triana, author of Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets? VaR Thu, 08 Jul 2010 21:45:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/7/8/From-JorionTaleb-To-ChoudhryTriana http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/6/28/Im-still-here-Trackstar I went away for a while, but never entirely left. Will try to resume my blogging responsibilities full-throttle. To be honest, I just write less in general these days (have a new job plus spent some time in book-promotion rehab). I did publish a VaR piece (another one!) recently (had an interesting reply from a famous author-academic, will share with you here shortly). Will run something largish on the impossibility of knowing in finance next month. Re Lecturing Birds, to be honest I am somewhat disappointed by the sales figures (10k give or take). Given the timeliness of the topic I was hoping for a more receptive response, but hey no one really knows why books sell or don´t sell. I still, naturally, like my humble tome very much. Will post stuff on the book business, I find it unique in that 99% of the makers of the product can´t make a living out of it. I can´t think of any other business where this applies. And even more puzzling is that people still want to be authors. Keep in touch. Miscellaneous Mon, 28 Jun 2010 21:07:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/6/28/Im-still-here-Trackstar http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/2/12/Quantitative-Echoes Heard through the media grapevine after 1997 Asian crisis and 1998 LTCM crisis (which almost destroyed the system): "The answer is not to reject quantitative finance but to be honest about its limitations. Models have their places but they must be coupled with more subjective approaches to risk, such as stress tests and scenario-planning" Heard through the media grapevine after 2008 credit crisis (which destroyed the system and almost caused a global depression): "The answer is not to reject quantitative finance but to be honest about its limitations. Models have their places but they must be coupled with more subjective approaches to risk, such as stress tests and scenario-planning" To be heard through the grapevine after 2015 sovereign debt CDO crisis (which would do away with the euro, result in the acquisition of Greece by private equity funds, and force President Palin to expulse California from the Union): "The answer is not to reject quantitative finance but to be honest about its limitations. Models have their places but they must be coupled with more subjective approaches to risk, such as stress tests and scenario-planning" Miscellaneous Fri, 12 Feb 2010 23:52:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/2/12/Quantitative-Echoes http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/2/2/On-Jodaism--A-Reply-To-Aaron-Brown First of all, let me say that I am honored that someone of the stature of Aaron Brown decided to review my Lecturing Birds on Flying. Having clarified that, I wish he had chosen a more regular venue for said exercise; Amazon.com is more than fine, but whatever happened to GARP Risk Review, Wilmott Mag, or the WSJ? Given Brown´s excellent writing skills I for one would have loved a lengthier, more formal take on my humble tome. But a shortish, informal review on Amazon is all we´ve got, so let´s face reality and delve into the analysis. The review is a mix of positive and negative assessments. Such apparently unenthusiastic response may throw some authors back, but not me. I am too busy glowing in the fact that Brown finds good stuff buried within all those bothersome inverted pluperfect subjunctives (he says I remind him of Joda, of Star Wars fame). I can proclaim that I wrote a book that Aaron Brown found (somewhat) useful. That´s a very good thing. For not only is Brown a very prominent risk professional, or a very gifted and thoughtful "financial intellectual". He is also a renowned defender of the quanty stuff. So when someone like that is willing to compliment a book that goes heavily at the quanty stuff, you know that at least something has been done right (of course, I personally believe that a lot in the book is right). Let´s stop basking in short-lived, modestly-served glory, and turn our attention now to Brown´s criticisms. He claims that I lose out to BSM, VaR, and other theoretical "straw men", that my views are deeply misinformed. I beg to differ. I think here I have the advantage of not being a quanty type and thus of having taken the approach of looking at the historical record and the opinion of other, much better informed, experts when analyzing the validity and wholesomeness of the best-known models, rather than try to engage them on mathematical grounds (though, naturally, I do attempt to dissect the essential technical deficiencies). So when I declare VaR a failure, I do so based on its behaviour during the credit crisis or during the Asian-LTCM meltdowns. I do it based on the monstrous shortcomings of the tool during crunch time out there in the real world. I think my book is the first ever to actually collect and display the actual data: what figures VaR registered, the number of exceptions incurred, how actual trading losses deviated from VaR. All that data comes straight from banks´ regulatory filings, a pretty solid source. I wouldn´t exactly call that misinformedness. Same with BSM. My analysis of its role in the 1987 crash comes from official reports and other well-informed sources. My interpretation of what the volatility smile means in terms of the model´s reliability has been espoused by many through the years. And my summary of the Taleb&Haug paper is exactly that, a summary of a pretty trustworthy reference. So the foundations on which my lambasting of BSM rests also have the smell of solidity. I detect little misinformedness here too. Brown says that risk management is not about predicting, but rather about preventing disasters. Fine, but then why use VaR? VaR is a predictor, with a degree of confidence. And VaR can´t, almost by definition, capture disasters. Many VaR lovers have, serendipitously, ceased to endow VaR with the predictor label following the (VaR-fueled, VaR-exposing) credit crisis. Upon seeing all those exceptions (80 real versus 5 theoretical in the case of UBS for 2007-2008, I seem to recall) it is only natural that they would want to deviate out attention from hitherto familiar arguments a la "99% VaR will not be exceeded more than twice a year". But that does not mean that I am wrong when, upon studying the hard evidence, I dare to proclaim that VaR failed monstrously. Finally, Brown asserts that institutions with bad risk management fail only once. By that definition, VaR is clearly bad risk management. Anybody remembers Bear Stearns, Lehman Brothers, or Merrill Lynch? They used VaR for risk guidance and capital-charge setting. They had never failed in their entire combined history (three centuries?). All it took for such holly tradition to be broken was the concurrent abidance by a statistical tool that encouraged, allowed, and afforded the vast accumulation of the most toxic positions ever witnessed on Wall Street. VaR made sure that those legendary, erstwhile indestructible institutions would not fail a second time. When VaR kills you, it kills you for good. Books Tue, 02 Feb 2010 20:35:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/2/2/On-Jodaism--A-Reply-To-Aaron-Brown http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/1/16/Quantitative-Madoffs Let´s think about disgraced ?financier? Bernard Madoff for a second. Why is he the uttermost epitome of inappropriate conduct? Why is he the poster child of fraudulent behavior? Why is he unremittingly fingerpointed as the exemplar of badness? Well, if we had to boil it down to a very quick rationale, it would be the following: Mr Madoff knowingly and vastly lied in matters related to financial activities, and such sizeable untruths caused untold despair and economic setbacks to others. That, in a nutshell, is his legacy to future explicators of financial happenstances. He will always be known as someone who produced deceitful fabrications that enriched him while impoverishing the many who got conned into believing. My question is, shouldn´t we judge the rest of participants in the financial game by the ?Madoff standard?? That is, shouldn´t those who, a la Bernie, contribute to monetary pain by purposely and deliberately duping the world also be loudly accused of fraud, relentlessly disgraced as scammers? I need to ask this, because it is not immediately obvious that those who share Madoff´s affinity for financial hoodwinking and capacity for social havoc-wreaking get called to task. Take the promoters of quantitative finance. The complex mathematical concoctions that have been increasingly used in the markets for the past three decades have contributed to non-negligible chaos. In fact, it wouldn´t be far-fetched or insultingly irrational to argue that the employment of analytical models was behind the worst three market crisis since 1929. While an army of deniers remains hidden behind academic walls, it is by now pretty much conventional wisdom among many practitioners, analysts, and regulators that things like the Black-Scholes-Merton option pricing formula, the Value at Risk capital charge-setting radar, and the Gaussian Copula CDOs-rating model decisively aided and abetted the unleash of the malaises of October 1987 (one-day 25% drop on Wall Street, threatening the system), September 1998 (LTCM blow up, threatening the system), and 2007-2009 (credit crisis, destroying the system). But even those who do admit to the failings of the quanty concoctions have typically shied away from being too harsh on the concocters and their intentions. When analyzing the excusing that has typically followed the (chaos-igniting) malfunctioning of the math, it is impossible not to distill the main message: the modelers were acting in good faith, honestly trying to model the market as accurately and truthfully as possible; unfortunately, things went awry once the analytics hit the street, but such outcome (aka as ?the perfect 1000-year storm? among financial theoreticians) could not have been predicted by anyone. In other words, the argument would go, there was no equations-driven deceit. The math that was peddled would have been peddled in good faith, the models would have been prospectively assumed to be sound and trustworthy, to the best of the modelers? abilities. Lots of folks may have lost tons of money as a result of imbuing the math into finance, but not, the excusers would point, as a result of the mathematicians cheating anyone. Or did they? Bluntly put, the assumptions of many of the most widely used financial models are so egregiously unworldly, so alarmingly unrealistic, so impossibly unseemly that it is very very hard not to contend that many peddlers of the quantitative snakeoil must have been perfectly aware all along of the meaninglessness of some of the solutions. Possibly even of the danger that they pose. But the incentives not to share such beliefs and to instead defend the model´s robustness may have been irresistibly tasty. As long as the math is assumed to be reliable and sound, the mathematicians can enjoy the glamour and paycheques of finance. And the math can be a wonderful alibi for banks to engage in the kind of trades that they love most. By conveniently (and widely unrealistically) projecting very little risk ahead, VaR and the Gaussian Copula, for instance, decisively allowed Wall Street and the City to play the Subprime CDOs game that eventually killed us all. If you are a modeller, are you really going to out the models as useless and dangerous or are you going to continue to trot along and profitably rate garbage as if it were gold? Naturally, by choosing the latter approach you would be incurring in intellectual fraud. People endowed with prestigious doctorates, and who might have previously dreamed of academic glory and yearned for the pure discovery of knowledge, would be corrupting sacred scientific methodologies. They would have contributed to transforming advanced mathematics and statistics into misleading sales pitches in search of a quick buck. They would be (knowingly) contributing to a lie that clouds understanding and that puts the world at large in undue danger. Is that a lesser crime than the one committed by Bernard Madoff? Miscellaneous Sat, 16 Jan 2010 23:32:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2010/1/16/Quantitative-Madoffs http://www.wilmott.com/blogs/PabloTriana/index.cfm/2009/12/9/I-Went-To-The-Best-Place-In-The-World I recently met some American businesspeople and I mentioned to one of them that I had attended NYU's B-school. He promtly replied that he had gone to Columbia´s B-school. I offered the interesting fact that a staff member at NYU once told me that "at least 80% of the MBAs here are Columbia rejects". This emboldened the Columbia grad, who went on to promptly concur and to publicly conclude that he saw no reason why someone who gets into Columbia´s MBA program should go to NYU´s. Unbeknownst to him, his work colleague (the person who literally sits next to his desk) has an MBA from NYU and, intriguingly serendipitously, happened to have listened to our conversation from a hiding distance. She quickly joined our conversation to defensively point out that she had never applied to Columbia. Whether or not most NYU MBAs suffer from "Columbia envy" (a waste of time if you ask me; they should instead be busy congratulating themselves for having attended one of the best educational institutions on the planet) does not directly concern me as a graduate from NYU´s B-school. For you see, I did a Master of Science (Stats + Finance), not an MBA. And that´s why I know that I will never feel academically second to any of NYU´s academic rivals, Columbia included. For one simple reason: the program I attended was the best one in the world at what it did. Top of the tops. I chose NYU´s MS because 1) I was looking for a quantitative finance program (as I wanted to go into derivatives and to differentiate myself), 2) I was looking for a leading business school (as the resources and social and professional opportunities are way superior), 3) I wanted to be in NYC (for the obvious social, cultural, and career reasons). NYU Stern was the only institution that guaranteed that glorious triad. And that´s why I chose to go there. No other quant finance program in the world could offer that unbeatable combination of top b-school, Manhattanism, and Wall Street. No other quant finance program could beat NYU Stern´s offering. I enrolled in a peerless, unbeatable program. Such course of action on my part has delivered me tons of positives ever since. Following my recent encounter with the Americans, I have discovered a new, hitherto undiscovered, advantage: whenever someone brings up their Columbia (or Harvard, or Wharton, or MIT) affiliation I, unlike perhaps many other NYU grads, can´t succumb to the temptation of inferiority. I know perfectly well that my program was superior to all the competing alternatives. And that´s why I feel, now more that ever, awesomely proud of my NYU affiliation. It´s just nice to be able to claim that you went for the best, second to none. (Of course, this topic is less than insultingly relevant in the cold hard real world of manly work. I live by the motto that "movement is demonstrated by walking", so I don´t care much where one went to school when it comes to professional undertakings. Hey, I don´t much care whether one went to school at all. Perhaps, as Malcolm Gladwell suggests, we should be forced to entirely erase our academic history from our resumes!) Education Wed, 09 Dec 2009 17:33:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2009/12/9/I-Went-To-The-Best-Place-In-The-World http://www.wilmott.com/blogs/PabloTriana/index.cfm/2009/10/12/Reuters--Dynamite-The-Nobel-In-Economics http://blogs.reuters.com/columns/2009/10/09/dynamite-the-nobel-prize-in-economics/ October 9th, 2009 Dynamite the Nobel prize in economics Did you know that worms cause cancer? They don?t, of course, yet in 1926 Johannes Fibiger won a Nobel Prize in medicine for this ?discovery.? The Nobel committees for science prizes rarely make such amusing blunders, but those awarding the medal for economics have a long history of endorsing ideas that are useless, incorrect and even dangerous. With the latest winner of the $1.4 million windfall due to be named on Monday, the case is stronger than ever for scrapping the prize altogether. The economics award ? created in 1968 by Sweden?s central bank ? has always been the odd man out. Far from celebrating those who have ?conferred the greatest benefit on mankind? as Alfred Nobel intended, the economics prize has done more harm than good. The prize has fostered a faith in economists that is often misplaced. Friedrich Hayek, who won in 1974, said he would have advised against creating the award. The title, he said, ?confers on an individual an authority which in economics no man ought to possess.? Laureates, he suggested, should be required to take ?an oath of humility ? never to exceed in public pronouncements the limits of their competence.? Sadly, economists, as a caste, have showed no such humility. The Nobel imprimatur has encouraged us to exaggerate the scientific quality of the dismal science. Unlike their counterparts in physics, chemistry and medicine, economists have precious little predictive power. Lately, there has been much soul searching about the failure of economists to anticipate the 2008 meltdown. But given the profession?s history it would have been surprising if they had. Over the past 20 years economists have failed to forecast any of the major twists and turns of the U.S. economy. Economists, as labor leader George Meany once grumbled, is ?the only profession where a person could be considered an expert without having once been right.? Worse still, the Nobel committee has set its seal on ideas that have been extremely toxic. Nobel Prize-winning theories were behind the biggest market meltdowns since the Great Depression. In 1987, wide acceptance of the Black-Scholes-Merton option pricing model helped turn a market stumble into the worst one-day fall in Wall Street history, threatening the entire system. The model was rejected by traders, yet a decade later Robert Merton and Myron Scholes picked up their check from the Riksbank. Or take Value at Risk models ? backed by the Nobel Prize-winning portfolio theories of Harry Markowitz ? which was culpable in both the panics of 1998 and 2008. These models helped justify skimpy capital ratios in the run-up to 2008. ?These theories have managed to transform tranquillity into turbulence, creating crises out of nowhere,? says Pablo Triana, author of ?Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?? He adds: ?The Nobel Prize helped give them respectability.? And Nobel-endorsed economic theories helped justify the aversion to regulation showed by policy makers like Alan Greenspan. A long list of laureates from the Chicago school from Gary Becker to Edward Prescott helped promote the idea that governments should stand aside. If the Swedish central bank wants to give away 10 million kronor a year, that is their business. But the prize should not be allowed to coast on the prestigious Nobel brand. Surviving relatives of Nobel are right to ask that their name be taken off the prize. Aside from a new name, the prize should also come with a label: WARNING: These theories should not be used by everyone. Side effects can include: financial crises, turbulent stock markets and banking collapse. Miscellaneous Mon, 12 Oct 2009 16:36:00 --0100 http://www.wilmott.com/blogs/PabloTriana/index.cfm/2009/10/12/Reuters--Dynamite-The-Nobel-In-Economics