Green Black
The mathematical models used by hedge funds, banks in money centers, and major investment banks, even as boys smart at Goldman Sacks, appear to have risk assessment and the frequency at which "rare" statistically virtually impossible to produce events actually occur all wrong.
A black swan is an event that is really disastrous if it does occur, but fortunately as investment models, occurs very rarely. If rarely, in fact, it makes no sense to worry about. A recent black swan that hit the stock markets of the world squarely between the eyes and still flies like crazy, is the collapse of the subprime mortgage market.
Mathematical models have excluded the proportion of mortgages that could go wrong with such a low number that the effect of a few to go wrong from time to time, we expected to have little effect on the mortgage portfolio overall. Clearly, given the events last year, something very badly incorporated into mathematical models.
A fat tail is an event or events serious are considered well outside the boundaries of what is considered normal. A bell curve is generally used to demonstrate the distribution events. If we happened to plot a graph, because events occur normally in most cases the greatest number of demonstrations will be provided, at or very near the center of the curve.
The events that occur a little less than normal would be fomented a little farther from the center, until finally the rare events are brought to the edge of the graph. Once plotted a graph the graph would have the shape of a bell, hence the name bell curve.
Statisticians of the House Financial placed in their specific model probability of occurrence of events at the end of the bell curve. Often as standard deviations away from the standard events should occur once in a hundred thousand years, if at all. Imagine their surprise and did not believe when a number of these events occurred one after the other giving them a Bell curve big cock unexpected.
What to do when the problem? How could so many very smart people find models of investment risk that proved to be incompatible with real world events? How could so many brilliant Wall Streets con men, eeerrrrr, sorry, financial managers, Chairman and CEO, expand their businesses in areas such as repackaging make risky loans to people who lack the capacity to repay the investment packages that include a AAA rating? How, indeed?
A good summary of the black swan and the fat tail problem is this quote: "This is not what you do not know that you do gets into trouble. That's what you know for sure that just is not so "(Mark Twain?).
Mathematical models in May good job in a world theoretical. In this world of economists, mathematicians and investment banking analysis, you can buy the theory that humans are rational creatures and will always take steps that are in their own interests. They also buy into the nonsense that markets are always right, that The current price for a title should be the correct price, because at that time the market says.
Unfortunately, humans are often not rational at all. They have a tendency to follow each other around. The herd instinct is strong. Humans can Stampede one after another in a direction, then say a black swan event occurs as two hijacked planes crashing against the Twin Towers World Trade Center and almost immediately herd reverses course and fees in the opposite direction.
Unfortunately, the mathematical models used by the big boys to identify and interest rate risk can not get a grip on emotions and human behavior. Fear can turn into greed and avarice in fear faster than you say can buy or sell. In financial markets, whether equities, bonds, commodities, or forex, the effects of fear is often multiplied many times because of the leverage that many investors use in structuring their investments.
Under black swans and fat tails extreme stress seem to thrive. The events that the models should happen only once per million years may occur several times a week. Maybe the smart big boys are not as smart as they think they are. Do they really deserve to pay millions of dollars a year in bonuses on top of salaries of several million dollars? Is this late stage rape and pillage of capitalism average investor has come?
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