Beware of Greeks Bearing Formulas
I take the title of this post from Peter Klein of the Organizations & Markets blog. Peter, wrote an excellent post on the complexity of risk models and their recent spectacular failure (which can be found here). In addition to linking to Peter’s post, I would like to present a New York Time’s article which details the failure of including the “human factor” in risk models. Click here to skip the introduction and read the full article on the recent failures of modeling human factor risk
Article Introduction (Via NYT)
Today’s economic turmoil, it seems, is an implicit indictment of the arcane field of financial engineering — a blend of mathematics, statistics and computing. Its practitioners devised not only the exotic, mortgage-backed securities that proved so troublesome, but also the mathematical models of risk that suggested these securities were safe.
The models, according to finance experts and economists, did fail to keep pace with the explosive growth in complex securities, the resulting intricate web of risk and the dimensions of the danger.
But the larger failure, they say, was human — in how the risk models were applied, understood and managed. Some respected quantitative finance analysts, or quants, as financial engineers are known, had begun pointing to warning signs years ago. But while markets were booming, the incentives on Wall Street were to keep chasing profits by trading more and more sophisticated securities, piling on more debt and making larger and larger bets.
Article Excerpts (Via NYT)
“Credit-default swaps, though intended to spread risk, have magnified the financial crisis because the market is unregulated, obscure and brimming with counterparty risk (that is, the risk that one embattled bank or firm will not be able to meet its payment obligations, and that trading with it will seize up).”
““Complexity, transparency, liquidity and leverage have all played a huge role in this crisis. And these are things that are not generally modeled as a quantifiable risk.”
“The Fed economists concluded that the risk models used by Wall Street analysts correctly predicted that a drop in real estate prices of 10 or 20 percent would imperil the market for subprime mortgage-backed securities. But the analysts themselves assigned a very low probability to that happening.”
Click here to read the full article on the recent failures of modeling risk
Relevant: Click here to read a similar article titled “Beware of Greeks Bearing Formulas”
