I received an email from a reader:

"In case you missed it, I just read a quote by a 'senior Citibank executive' in which he claimed (after the 6 or was it 11 billion dollar writedown, and counting), that their risk management system worked perfectly, but unfortunately it was based on incorrect assumptions!!! "

For my next book [on discovery, empiricism and anti-Platonism] I am finding references on very interesting constants of charlatanism: some top-down rationalism, often masked under some garb of authority. CHARLATANS ALWAYS SEEM TO MAKE SENSE INTELLECTUALLY, which conceals their empirical defects. We have plenty of awareness on charlatans in medicine, but very little in socio-economic life, which is the reason mathematical, financial, and neoclassical economics exist. I found many attacks on what Hayek called later scientism, but these do not penetrate consciousness. And they contain few actual empirical tests.

The idea you guys need to register is just as pre-clinical medicine, the discipline killed more patients than it saved, so does risk management and quant finance CREATE MORE RISK that they reduce.

There are several classes of charlatans in finance. 1) Those who do it for the love of autistic-style pseudoscience (say any of the math-finance honchos), 2) Moodys, International Association of Financial Engineers, Jorion-style etc. charlatans who do it for the money, etc. 3) Finance professors who do it for both.

You can find links to the cognitive dissonance literature: how people resolve their conflict by rationalization. Some less sophisticated charlatans do ad hominem attacks to try to discredit the messenger in order to change the message. It did not work with me (it just sells more books).

I wonder why other than Pallop Agsupun and I nobody has tested whether past variance predicts future tail events (it doesn't) or whether past tail events predict future tail events (they don't).

One of the IAFE quacks once announced at a lecture "Value at Risk is necessary but not sufficient". I replied in my lecture: it is like saying "Astrology is necessary but not sufficient". Quacks do not know history of quackery.

More, later

I am at the Edinburgh literary festival and the last thing I care about is you finance people.

I've been swamped by emails telling me that I was right (forwarding stories about "25 sigmas" by the Goldman Sachs CEO --who needs to be replaced or banned from speaking to the press -- or the Rothman guy in the wsj on 1 in 10,000 year events).

I don't understand these emails. It is as if I didn't know that I was right. Tell me what I don't know.

Marcos Carreira got it right. No wonder he gave me a Brazilian address to send him a copy of TBS. People in Braziou know about high interest rates.

The idea of follows: something that is supposed to drift BUT DOES NOT DRIFT is volatile.

Consequence: when a currency has a high interest rate, spot volatility is totally irrelevant. Using HVT on Bloomberg is not an intelligent idea.

The problem with the question: 100% interest rates can be ambiguous when translating into daily rates. I meant the daily equivalent of 100% interest rates.

So where r is the daily rate, the answer is :

STD= [Sqrt[ Sum [i=1, i=22] [ (0 - r)^2]/22] Sqrt[256] (annualized)

MAD= Sum[i=1,i=22][Abs[0-r]/22] (daily there will be another post on annualization of MAD)

If you use daily r of .4, the answer is 6%. Marcos used a lower daily r but I assumed that he was right and that the interest rate I used in my question was ambiguous.

I got an intelligent answer from Leon Pollard, that monthly volatility should be about 4% (if you measure volatility monthly) --but Marcos beat him to it.

I have another 92 Quizzes --I am in Budapest and I saw a bunch of post Empire men playing chess in a Belle Epoque style spa, standing in a pool of warm spring water. I realized that I find option quizzes far more fun than chess.

We Don’t Quite Know What We Are Talking About When We Talk About Volatility

paper

http://ssrn.com/abstract=970480

When you ask someone the following question: A currency has 5% interest rates (can be generalized to any security). The base currency (costs of funds) is 5%.

The underlying moves up 1% a day for 22 days in a row. How do you compute volatility (Standard Deviation) for the PURPOSE of decision-making (option pricing)?

Almost everyone I've quizzed throughout my career answers: 0% volatility. Their spreadsheet functions using series of log returns also erroneously provide: 0% volatility.

Nonsense.

The real answer is 16% annualized.

Why? STD = Sqrt[(E[X-E[x])^2] MAD =E[|X-E[x]|]

When you are facing an uncertain outcome you do not expect the mean return to be 1% a day. You simply expect 0% drift. Therefore you should not center volatility around the ex post drift but the ex ante one.

In other words, the options would produce the P/L of 0 volatility if and only if the drift is expected to be 1%

The classical anticipating-nonanticipating strategy. AN OPTION BREAKS EVEN AT 16% VOL (+- some adjustment) NOT 0.

Corrollary

A currency has 100% annual interest rates [paid daily]. Base currency is 5%. The exchange rate does not move for a month. What is volatility (monthly, annualized)? Easy...

please send answers to gamma [at] fooledbyrandomness [dot] com

The winner gets a copy of The Black Swan . I will not offer to sign the copy (I hate to offer to sign my book ... my signature has nothing special ... )

Simply raise vol twice this time by increment DV. Compare the following Portfolio values (hence PV) PV[V] - PV [V+DV] and PV[V+DV]-PV[V+2DV] . If the second value is smaller (larger) than the first and one is long volatility, then he is short (long) the tails. Is the second value is smaller (larger) and he is short volatility, he is long (short) the tails.

Model Risk Effectively this exercise reveals more than fat tails --sensitivity to model errors, sensitivity to problems of distribution. In a way, everything starts and ends with NonGaussianism.

How can you figure out if an option book is short the tails? Move ONE single parameter, but twice. Hint: not complicated at all. Please send answer to gamma [at] fooledbyrandomness [dot] com

Simple: Just raise implied volatility and look at the delta. If the delta rises, then the book is look OTM calls and shorter OTM puts, i.e. long skewness --you want Expectation of the cubic returns E[DS^3] to be >0. In other words look at the sign of the DDelta-Dsigma.

The problem is that the analytical derivative is not sufficient since the effect might flip if you have way out of the money options that might "wake up" at higher volatility. So you should make sure that the reaction is monotonic. In other words you might have exposures to higher ODD moments of the distribution.

How can you figure out by MOVING A SINGLE PARAMETER if a collection of options has an exposure to the third moment of the distribution (i.e. short or long skewness)?

Please send replies to gamma [at] fooledbyrandomness [dot] com

I mean ONE SINGLE parameter.

I recall in my past life as a trader working for financial institutions that some desks, mostly bank units, did not want to deal with the volatility of the marks-to-market on a daily or monthly basis and ran "accrual" books. An accrual book is gradually marked throughout its life --so the trader knew pretty much, baring a "black Swan", what his P/L was going to be. Some also tried to escape the marks-to-market when they engaged in some arbitrages that should "converge" at expiration. They claimed to know what the value of the trade would be at expiration time T, so there was no need to mark immediately and deal with the vagaries of the marketplace. In their mind letting the market value these trades did not reflect the economic value of their books. The argument offered was "I will only unwind at expiration, not before". They were certain about it. They were as certain about it as people tying the know are certain that they are united forever.

I am writing this note because one day, in 2005, at a panel discussion, a board member of FNMA and an advocate of "modern finance" got emotional about the bad press related to some accounting irregularities that was supposed to have taken place at that firm. The panel discussion had nothing directly to do with FNMA or with accounting policies. It was about risk management. I thought of the argument proposed and realized that by not marking to market every single item in one's book one fell prey to model risk. It was the same type of epistemic arrogance that was behind the central planner: you set an equality between A and B by fiat. [It is not just some unpleasant member of the board of FNMA that falls prey to epistemic arrogance. Merton Miller took similar arguments when he defended the Metalgesselschaft traders who went bust trading short term futures against long term forwards. His argument was that "long term" things should be OK and that we should not have paid attention to the "short term" differences in market values].

Why Model Risk? The simplest of securities embeds model risks: the way the contract is described in your system may be missing a minor component. Minor, except... Say that I have the simplest of trades deemed fungible on my books: I am long a forward with Bank A and short the exact same one with Bank B. I may be hedged, but I have at least a credit risk there. Sometimes the smallest variations in the contracts can be significant. No two contracts will ever be exactly fungible unless they are legally offsetting.

Now the market knows that these contracts are not as identical as they are thought to be. Markets discover things faster than some slow-thinking regulator or overmathematized risk manager. When Russian options traded at 5 implied when supplied by a Russian bank and at 11 with a nonRussian institution, you had a marks-to-market risk not accounted for by models. The market knew it, not the banks.

Another sucker's problem is the classical forward-future "mispricing". The forward IS NOT a future, be it only because a future has cash-flow elements throughout its life, something the models miss severely. Many blew up on this.

A Safer System Many corporations do the following arbitrage. They buy plenty of companies, say n units. Say half the companies do well, the other half do poorly. All of them will be marked at cost on your books. You have a bad quarter: no problem. Just sell those that fetch a price higher than acquisition (i.e. books) and you will show a profit. GE does that routinely (Jack Welsh admits it in his memoirs).

The same with traders. When you let them "accrue" you end up having the books doing worse than market. If the trader has a profit, he takes it. A loss becomes accrued. It is like traders becoming "long term investors" when their positions are under water.

A system without opacity will be like Japanese institutions: seemingly less volatile, but exposed to large losses. (I compare this in The Black Swan to a dictatorship that shows political stability but incurs the risk of revolution compared to a country like Italy with a smaller risk of reolution but more fluctuations. Fluctuat nec mergitur.)

One good thing about hedge funds: unlike FNMA they mark to market. They have such bad press that they are forced to do so. Unlike banks and corporations they cannot play nasty games and fool their shareholders. Recall what Enron did with its "contracts". They may have other problems, but, at least, they are transparent.

Reduction and Platonicity

This problem resembles the more general one of the creation of categories and mental representations that simplify and reduce --it is necessary to simplify. Except that we forget that they aqre just simplifications.