Sunday, October 28, 2007

Quants meet Reality

The Quants on Wall Street this summer received a harsh introduction to reality and the impact of multi-sigma events in the market. Traditionally, significant dislocations that tear apart the fabric of mathematically driven funds occur about every 18 years based on historical analysis. Most quants ignore history and focus on short term back-testing studies; blindly confident in their belief that these events have been arbitraged out of the market by superior math and will never occur again. Akin to the railroad engineer holding his hands over his eyes while driving the train over the cliff.

In earlier posts, the phenomena of quants was touched on:
Will Someone tell the Financial Whiz Kids that their House is Built of Cards

A number of recent articles put the role of quantitative analysis and algorithmic trading in the limelight as the driver of recent market disruptions. The losses from in-house algorithmic trading desks have been extreme over the past couple of months as volatility spiked and pricing diverged from historic patterns. Morgan Stanley reported a $480 million loss in the third quarter from the bank's in-house equities trading desk that employed computer generated models to drive returns. Many other investment banks demonstrated similar issues while a number of hedge funds closed up shop.

Volatility puts algo trading under pressure

Nassim Nicholas Taleb discussed the impact of multi-sigma events on the market in his recent book “The Black Swan: The Impact of the Highly Improbable” “The term black swan comes from the ancient Western conception that all swans were white. In that context, a black swan was a metaphor for something that could not exist.” A Black Swan is a large-impact event that greatly deviates from the ordinary and is difficult to avoid. Taleb’s embedded thesis is that financial engineers are lulled into false complacency, not planning for the worst case and are never prepared for events that rip the fabric of their models.

The MIT Technology Review recently posted a pair of excellent articles about the role of financial engineers in the implosion of the derivatives market this past August; a crisis that is still unfolding. There finally appears to be a glimmering of understanding that the structured derivative market is a house of cards that can be crumbled by multi-sigma events, and it is just a matter of time until the Black Swan visits any leveraged market sector. The brick wall of reality trumps math every time… or in just a matter of time.

The Blow-Up: Part 1
In Wall Street's summer of scary numbers, all eyes were on the mathematically trained financial engineers known as "quants."

The Blow-Up: Part 2
How the financial engineers known as "quants" contributed to Wall Street's summer of scary numbers.

Black Swan

Black swan theory

Nassim Nicholas Taleb’s book can be found at: