Thursday, September 10, 2009

The Black Swan Visits Congress

Dave G. sent me this link today and I thought it was interesting. According to this article on the Huffington post. Congress is going to hold a hearing on the whether or not the usage of VAR (Value at Risk) is responsible for our current financial problems. 

I find this interesting because when I first learned about the concept of VAR, I was a bit troubled about the theoretical basis. The bread and butter of VAR is mean-variance. The region of interest in VAR is also the region that is the least well behaved (the tails).  In light of heavy tails, it seems awkward to use mean-variance methods to set multi std deviation confidence intervals.

From the article:

This Thursday September the 10th marks a historic development for both Washington and the financial markets. The US Congress' Committee on Science and Technology will hold a hearing on the responsibility of mathematical model Value at Risk for the credit crisis. As HuffPost readers know full well, I have long blamed VaR for the mayhem (remember: VaR allowed banks to build the toxic leverage that sunk them and the world). To my knowledge this is the first time that a financial theory is put on the spot like that, the inevitable consequence of having endured a theory-caused meltdown of biblical proportions.

My friend Nassim Taleb has been invited as expert witness by the Committee. That's a wise choice. Taleb has not only been a real derivatives trader for decades, but crucially has been warning about VaR's potential for destruction for at least 15 years. As I told HuffPost readers not long ago, he alone predicted what has just happened, including the term "bail out". Frankly, it was only a matter of time before VaR killed us.

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