The invalidity of risk models (or do I trust my VAR calculations)

10 November, 2007

To continue some of the stuff raised in The Black Swan I’ll discuss Taleb’s attack on financial models based on the normal distribution, this misuse of which he describes as the Great Intellectual Fraud.

I considered entitling this “Am I a fraud?” as the contention raised in the book that those who use such models are either idiots unaware of the problem or frauds aware of the problem, but content to sell their services based upon an idea they know to be wrong. On the surface of it I fall into the second category. Although I came out of a physics PhD on powerlaws in physical systems, aware of the what they imply, and know that financial timeseries typically have powerlaw tails (Mandelbrot work on this cited in my thesis). Despite this I still work day in day out with normal based models.

The first line of defence of myself would be that these are really the best we have. However Taleb’s contention is that financial models based on the normal distribution are so badly flawed that not only do they not miss the really significant risks (the big ones) by assuming them away, they go further and actually create them. Once we have constructed a model to reflect the risk, people trade and protect themselves on the basis that the model’s predictions actually reflect reality and that large, uncorrelated moves are exceptionally rare. This leads them into taking on additional risk, and leaves them worse exposed in the case of exceptionally large moves.
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The Black Swan

29 October, 2007

My original intention was to write a longish post discussing the main ideas. Rather I will do an overall impression here, and then do a few follow ups to talk about what I think are the interesting points.

All up I found The Black Swan an very interesting read. If you’ve read fooled by randomness then some of the arguments will have already appeared but certainly not all. The Black Swan is concerned with wild randomness, the randomness that according to Taleb dominates modern society. Fool by randomness largely concerns the randomness of games, what Taleb would describe as mild randomness. So mild that it is hardly random at all.

As we are reminded in several places in the book Taleb made his fuck off money (i.e. enough money to be comfortably independent even if not mega wealthy) in the 87 stockmarket crash betting on the fact that the market under-appreciated Black Swans. He doesn’t need to fawn to the establishment be it economics, philosophy or publishing and we get this tone all through the book.

While the book touches on finance applications its hardly a finance book. Rather Taleb considers it to be as much a work of Epistomology. His chief concern is with what he calls epistemic arrogance. He hates those who profess to know more than they really do know, be they economic modellers, historians or political scientists, but his chief enemy is the normal distribution which is described as the Great Intellectual Fraud. To use normal distributions in fields where it is easy to show are not normal (such as finance), is both fraudulent and causes Black Swans.

Its strong stuff which he backs with examples, logic and the findings of behavioural finance and similar studies. Its also fairly convincing for the most part. Its true we don’t need sophisticated statistical studies to find whether market moves are normally distributed. We only need the fact that we get 1 in 10,000 year events (as modelled by a normal distribution) occurring every few years. Risk managers who run such models (such as me) are either ignorant fools, who actually believe wrongly in what they do, or deceptive frauds who know better but persist in fooling others for the money. I’d contend I’m neither but I’ll discuss later on.

Anyway I leave the rest to further discussion. I particularly want to mention the Narrative Fallacy, which I have actually mentioned before, the problem of prediction as well as whether I really am a fraud, idiot, or neither.

More on the rental crisis hype

5 March, 2007

One of my pet hates is the “research” turned out by real estate industry groups which is always, shall we say, very optimistic whether talking about rental increases or price increases. So I was amused when a friend pointed out this article in the paper on the weekend.

Rather than showing a surge in rents, data from the New South Wales Government shows there was no growth in apartment rental bonds in the three months to December.
In Sydney’s inner suburbs, three-bedroom houses recorded growth of 3.6 per cent but two-bedroom houses also showed zero growth.

Of course this is for the end of last year rather than the start of this year, but it puts the predictions in perspective. As I stated before its not surprising that the real estate industry publishes favourable research to their interests. What is disappointing is that the media outlets, papers, television, radio commercial as well as ABC and SBS almost uniformly regurgitate this uncritically.

Media watch has a more comprehensive hosing down of media gullibility in the face of real estate industry “research”. A fine collection of misquoted tenants, and exagerated stories some being pushed by political parties.

Sydney rentals

18 January, 2007

There has been a bunch of articles in the SMH recently about how tight the sydney rental market is. This was a little disappointing given that we had just started trying to find a place the day the headline proclaiming a 20% increase appeared in the paper the day before we started seriously looking. As usual this was some “research” by one of the various property industry bodies which regularly come out with rosy predictions about sectors of the property market. Typical lazy journalism runs these articles without any scrutiny, indeed they’ve been predicting rebounds in housing prices the entire time its been going down.

The article had the desired effect, overnight some of the advertised properties increased their asking rent 10%, ringing to enquire about another on the following Saturday I was told that “the asking price has gone up because the owner read the article in the paper saying rents were going up 20%”, again they had jacked it up 10%, for a property that already looked a little pricey. Obviously if the prediction is wrong then the market won’t sustain these rises, but at least in the short term it will probably have the desired effect. I do wonder when this research stops being research and starts being market manipulation. Not all of the newspaper articles fall into this category, the discussion of the effect the changes to super rules are having is legitimate, but what I dislike is the hyped up price increase amounts.

My story has a happy ending. We found two places we like on the first weekend of searching, got offered both and took the one we liked best. Further out from the city now, we’ve gone from Glebe to Strathfield, which means I won’t be walking to work in the CBD anymore, but on the upside we now have about 3 times as much space and a yard for the little fella to crawl and soon run around in, but the upside is we are paying a bit less rent.

Update: Another article today but this time about house prices rather than rent. Two different surveys two different answers. Unsuprisingly the mortgage industry research, says

…a contrasting survey of 958 people by the Mortgage Industry Association of Australia (MIAA) and BankWest showed that Australians were becoming increasingly optimistic that house prices would increase in the next year.

The study showed that 42.9 per cent of respondents expected residential property prices to be higher in the next quarter, despite higher rates

(my emphasis)
where as a more independent poll found

A survey of 1,894 Australians by found that 68 per cent of respondents said that higher interest rates would force home sellers to cut prices, while 42 per cent expected house prices to fall in the next quarter.

Confusion over water trading

9 November, 2006

Tucked away at the bottom of this article about Australia taking up nuclear power is this bizarre statement about water trading which kind of demonstrates why people should think carefully before commenting outside their area of expertise.

Water and irrigation experts remain unsure about whether any of the measures decided on at Tuesday’s meeting of state and Commonwealth leaders would free extra water.

Peter Schwerdtfeger, emeritus professor of meteorology at Flinders University’s Airborne Research Centre, said he agreed that overallocation of water needed to be stopped, but with “precious little else” that the meeting decided on.

“Water trading as it stands now is an evil nonsense. It has allowed the fallacious belief to develop that water can be sold either upstream or downstream without any consequences.

“Water that is sold to NSW will not flow downstream and the bed of the Murray may dry out. It is not environmentally or economically viable.

“Water trading only works if you have a surplus of water … why don’t we encourage people to use water more efficiently?”

It could be that Prof. Schwerdtfeger has been taken out of context or misquoted, but it seems more likely that he doesn’t understand the basic point that trade, by putting a market price on water it implicitly results in it being put to the most more efficient uses.

I don’t think that anyone is under the illusion that water is a commodity that can be traded “without any consequences”. Environmental flows must be maintained, losses when trades occur over long distances and such are all issues, but hardly irreconcilable ones. Most importantly is trading is more important when there is scarcity, its barely necessary if you have surplus. Prof. Schwerdtfeger may be an expert in climatology, but when he’s talking about trading, I don’t think he has a clue.

Government plays Enviro-Santa

26 October, 2006

The government announced yesterday $75 million dollars for a 154 MW concentrated solar power plant to be built in rural northern Victoria. Although the Peter Costello claims its going to cost $280 million, the company building the project Solar Systems, say it will cost $420 million. An additional $50 million is being contributed by Victoria. Perhaps PC is talking about the private costs and has missed $15 million?

The company describes the technology like this.

The power station will use technology known as ‘Heliostat Concentrator Photovoltaic’ (HCPV). It will consist of fields of heliostats (sun-tracking mirrors) focusing sunlight on receivers. The receivers house photovoltaic (PV) modules, which consist of arrays of ultra high-efficiency solar cells that convert the sunlight directly into electricity. Photovoltaic literally means ‘electricity-from-light’. The heliostat control system, PV modules and cooling system are patented by Solar Systems.

Solar Systems has collaborated with US company Spectrolab (a Boeing company) to optimise ultra high efficiency space technology for earth based power stations. The resulting photovoltaic cell arrays are three times more efficient than typical solar panels. Further cell efficiency improvements are underway.
This is a new generation of solar technology,” Mr Lasich said. “The secret is to be able to make a solar power module work about 1500 times harder than typical solar panels. If you can do this at high efficiency using low cost materials, you have the recipe for an infinite supply of clean energy at an affordable price. “This new power station will demonstrate these principles and produce the most affordable solar energy yet generated.”

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Carbon Emission Trading

25 October, 2006

There have been a few interesting pieces around recently on the subject of carbon emissions trading. The first is The Economist (subscription only) noting some of the failures of the European carbon trading market, which has seen prices of CO2 emissions collapse due to the issuing of too many free permits.

In order to get industry to swallow this scheme, allowances were handed out free to companies, rather than being (as economists wanted) auctioned. In power-generation (Europe’s most-polluting industry) companies passed the price of carbon credits on to customers and pocketed the value of the allowances. According to a report by IPA Energy Consulting, Britain’s power-generators alone made a profit of around £800m ($1.5 billion) from the scheme in its first year.

As the article notes, this failure is not a reason to rubbish the idea of emission markets altogether, but it is a good lesson in the mistakes that can be made and the need to either slash the number of permits or auction them off if the scheme is going to be worthwhile.
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