The Quants May Not Be Able To Prevent The Next Meltdown
By Robert Lenzner, Former Contributor
Jan 31, 2012
The Rutgers Ist Annual Quant Summit at NASDAQ on Times Square last night to celebrate the role of quants in today's financial markets showed that too much confidence in arithmetic models, even when invented by Nobel Prize mathematicians, are not foolproof solutions for avoiding risk.
After all the fascinating war stories were related by our fine panel, Bob Litterman, Leslie Rahl, Eli Ayache and Bruno Dupire , there was this almost embarassed admission that quant solutions to protect against risk and the dangers of volatility may not necessarily protect against the exaggerated level of confidence that existed in Wall Street in 2007, prior to the 2008 meltdown.
As Bob Litterman, former Goldman Sachs Risk Officer and chairman of the Kepos hedge fund put it, "We are not pricing risk appropriately-- which led to the financial collapse. And if we don't change our ways soon, it could lead to a much larger catastrophe in the future."
Risk in Litterman's mind, has many elements; it's more than the amount of leverage used; It's liquidity in the marketplace; its the quality of the counter-party on the other side of the trade, its the business involved. Just saying you are using "Value At Risk or VAR, an often used model, is not a sure protection against any of these risk factors going against you. That's because the VAR dollar figure presented in the financial statements of Wall Street firms, does not present an adequate pricing of the dimensions of risk. No one can measure all of the many different dimensions of risk" and place an accurate projected figure on it.
Or as Elie Ayache, CEO of ITO 33 and author of "The Blank Swan, The End Of Probability" put it to the Rutgers MBA students; "There is no safe way to measure volatility." Before the October 19, 1987 stock market meltdown of 23% on the Dow Industrials took , there had never been volatility of more than 40 with respect to stock prices. Most attempts to hedge risk took that VIX rate of 40 into consideration if they had time. But, as it turned out, the rate of volatility that day rose to 80-- double the previous peak-- throwing all strategies used for protection out the window. I personally knew the largest options trader on the Amex, who was wiped out by the volatility.
Leslie Rahl, managing partner of Capital Risk Advisers, who ran Citibank's derivatives operation, underscored that mathematical models are only an approximate version of reality. Rahl reminded the audience of 250 Rutgers MBA students and faculty that before 2007 the worst decline in housing prices in the US had been 20%. So, whatever structured securities were used to hedge that anticipated decline of no more than 20%-- could not be protected insurance if some securities were to decline 60% to 80% in value.
That bloodbath has resulted in new regulations on Wall Street, less borrowed money being used, and a substantial reduction in the use of structured finance notes that emply sophisticated derivative formulas.
Despite these very real problems, as the moderator of the panel, I spelled out how widespread quantitative methods were being used in corporate finance, in passive investing techniques like indexed ETFs, in essential risk control, and in the high frequency trading that has taken over 53% all stock executions, and now spreading to the buying and selling of bonds, commodities and currencies-- as well as to vibrant geographic areas like Southeast Asia.
It was a 2 hour seminar for MBAs who are working towards a degree in Quantitative Finance. There were many impressive young Chinese who are ambitious to learn the ways of Wall Street, and seek their fortunes in the brave new world of quantitative finance-- even with all its attendant dangers.
What's impressive is that a 24 year old student, John Iborg, president of his class a would-be MBA in the Master of Quantitative Finance Program-- not the Rutgers faculty-- came up wit the idea about educating his peers in one of the most crucial issues of finance; how to control risk, if possible, to prevent another meltdown like 2008 when trillions of dollars were lost by investors.