Tail Risk Killers: How Math, Indeterminacy, and Hubris Distort Markets

Tail Risk Killers: How Math, Indeterminacy, and Hubris Distort Markets

by Jeffrey McGinn
     
 

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Reshape your investing strategy for an increasingly uncertain world

“An engrossing, fast-paced, terrific read for anyone interested in the financial imbalances due to too much reliance on math and too little respect for indeterminacy.”
—Tyler Durden, ZeroHedge.com

The world does not unfold according to a fixed

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Overview

Reshape your investing strategy for an increasingly uncertain world

“An engrossing, fast-paced, terrific read for anyone interested in the financial imbalances due to too much reliance on math and too little respect for indeterminacy.”
—Tyler Durden, ZeroHedge.com

The world does not unfold according to a fixed set of rules. It is a dynamical system whose evolution looks like a bell curve with fat “tails.” The same is true of financial markets. However, every day we rely on the certainty and precision of mathematical strategies that assume the contrary to control and grow wealth in markets.

Tail Risk Killers shows you how the rigidity of model-based thinking has led to the fragility of today’s global financial marketplace, and it explains how to use adaptive trading strategies to mitigate risk in impending market conditions.

Risk management veteran Jeff McGinn pokes holes in prevalent assumptions about how financial markets act that tend to underestimate the likelihood of occurrence of extreme events. Through clear, conversational writing, real-world anecdotes, and easy-tofollow formulas, he provides a glimpse into the way tomorrow’s successful traders are viewing financial markets—with an eye for probability distributions. While illustrating how to protect your assets from tail risk, he shows you how to:

  • Implement the six axioms for risk management
  • Prepare for the unintended consequences of central banks suppressing tail risk
  • Identify and avoid the dark risks hidden in today’s derivative-laden financial system
  • Anticipate the fate of credit default swaps that may not face extinction

McGinn argues that the intervention of central banks has robbed global markets of their opportunities to adapt, but this highly relevant book shows you that it is not too late to adapt your portfolio to survive the extreme events that happen more often than popular financial models suggest.

Tail Risk Killers helps you discover useful information and processes beyond the focus of industry standards, helps you connect the dots of evolving trading strategies and time your next trade for maximum profitability.

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Product Details

ISBN-13:
9780071784917
Publisher:
McGraw-Hill Education
Publication date:
01/06/2012
Sold by:
Barnes & Noble
Format:
NOOK Book
Pages:
384
File size:
23 MB
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This product may take a few minutes to download.

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TAIL RISK KILLERS

How Math, Indeterminacy, and Hubris Distort Markets


By Jeff McGinn

The McGraw-Hill Companies, Inc.

Copyright © 2012Jeff McGinn
All rights reserved.
ISBN: 978-0-07-178490-0


Excerpt

CHAPTER 1

Default-Cost Asymmetry: Humpty Dumpty Was Pushed


Even in discounting economic conditions, people have a tendency to think in terms of extremes. For this reason, the outcomes investors assign to the future are pretty binary: über-deflationary collapse or hyperinflationary explosion. Why does everything have to be so über and hyper? Whatever happened to flat prices and high inflation?

It is true that the world's financial tail-risk killers—central banks and politicos—do everything they can to preserve the status quo, but in the end, all their effort amounts to jousting with windmills? Nature is too complicated, crafty, and feral for policy to fix everything. Time and the path of least resistance are the only cures. Determining just where those paths go is a tricky matter.

Mother Nature either will be allowed to get her groove on or she'll burn the club to the ground.


THE PRIMORDIAL SOUP KITCHEN

Objective reality is the basic structure of the entire universe. It consists of particles in fields of force. Human beings regulate their interface (i.e., cold, hunger, hardship, joy, satiety, comfort) with objective reality by constructing social reality. This reality adheres to or deviates from a set of reference rules generated by human-created institutions. These institutions, under normal circumstances, self-regulate (for example, legislatures, Federal Open Market Committee) and react to changes in human preferences (for example, as democracy places an upper bound on corruption and transfers power). The interaction of these institutions is where things get complicated and interesting. From human social interactions emerge new self-renewing institutions such as legislatures that create and interpret laws as circumstances change. Legislatures and courts interact with each other in ways that can sustain each other. Either institutions are sufficiently rigid to endure the stresses of time and path resistance without change, or they have enough flexibility to adapt and go with the flow.


Complex Adaptive Dynamical Systems

People adapt, learn, and react in ways that make their behavior nonlinear and complicated. This makes society a complex adaptive dynamical system—an unstable system with unique and interesting features. Complex adaptive systems are self-organizing—interconnected in ways that create vicious and virtuous cycles. The people and institutions they create mediate objective reality by constantly adapting behavior. The evolutionary purpose of individual parts of such systems is to find deficiencies and to fill niches that remedy these problems. If successful, they replicate—as when bureaucracies grow and expand their sphere of influence by becoming more interconnected to other parts of the system. In turn, the system itself gains properties that the people and institutions making it up don't have when viewed in isolation.

These kinds of systems explicitly work to reduce complexity. For example, humans live in groups, and group life is regulated by institutions that stabilize social interactions. This is why there are stop lights. The alternative is daily auto pileups on the drive to work every morning, capital structure instead of pervasive theft, and hopefully, elections instead of revolutions. The system itself generates rules to make interactions durable and predictable because it transforms data into the knowledge on which interactions are based. In turn, it supports more complex rule-generating institutions.

All complex adaptive systems require this type of complexity reduction, and it coincides with variance reduction in the behavior of parts of the system. There are unspoken norms and rules of behavior for just about every circumstance in polite society.

When interacting parts of systems have too rigid regularities, though, aggregate behavior can become uncontrolled because the system as a whole loses flexibility. Rigidity increases system entropy. In effect, entropy makes things more predictable and robust to small shocks at the level of personal behavior but makes an aggregate response to large-scale condition changes unpredictable. Here is where expectations cluster around a single viewpoint. Society rewards members who adapt and do not cling to past reference points without reservation until disaster ensues.

Social realities are structurally unstable because of this rigidity. This means that certain shock events, such as the default of a small municipality or country, dramatically affect the nature of the entire system, not just a small part of it. For example, financial markets exhibit an ever-increasing degree of interaction among participants. Correlated behavior between different participants of the system becomes so strong that even a small shock to a few participants causes them to act in a certain way. Because of the correlation, it will lead to the same action coordinated among others. The coordinated action cascades through the market like falling dominos, resulting in at least a greater possibility of an extreme outcome, such as a crash or a melt-up.

Shocks can come out of the blue, such as North Korea detonating a nuclear device in a ship docked in Singapore. Other shocks can occur when institutions internal to the system reach a critical mass, such as the London Interbank Offered Rate (LIBOR) exceeding 2-year yields past a threshold. When shocks such as these happen, the system has potential to undergo bifurcation—when transitions from state to state quickly evolve in increasingly complicated evolutions for a time and then collapse into simpler behavior. Depending on the flexibility of the system, larger shocks can be disruptive, painful, rejuvenating, or all three.


The Potential for Collapse

Whether or not a system collapses depends on its attained complexity and how close that level of complexity is to the system's threshold limit for handling complexity, beyond which it collapses. For such unstable systems, chaos is what lies between order and collapse. Human systems need complexity in order to use resources efficiently, but that complexity needs to be balanced and controlled—otherwise, it will destroy itself.

Progress depends on the "right" amount of innovation. When innovation is too low, societies stagnate. Populations containing erratically acting members are often at an advantage when interacting with members who rigidly adhere to existing rules because they are more predictable. When there are too many crazies on the loose, innovation becomes too high, and the system breaks down because it is impossible to know the best possible actions.

What lies between order and chaos is the internal tension between self- regulating behavior that enhances stability and destabilizing mutation that exploits predictable behavior successfully. A common intuition is that systems of this type have the best outcomes when they are at the "edge of chaos"—meaning not too rigid when change is needed and not so fluid that good ideas can't be identified.

Humans produce risk as a by-product of progress. It emerges from within the system itself as it adapts to favorable and unfavorable circumstances. Therefore, as complexity increases, risk increases. As risk increases, the power of history as a predictive framework fades. At the threshold between order and chaos, there is no adequate way to identify how the future will take shape and where punctuated, game-changing events emerge.

There's no stopping this. Fed policy, your senator, Zhu Rongji, me—we're all a part of it. Time is going to take us where it wants to. Enjoy Mother Nature, and hope that she enjoys you.


INTERCONNECTIVITY AND THE SYNTHETIC GOLD STANDARD

Societal changes that appear tiny on the surface can have the most impact because of exponential effects over time. For example, the gold standard of a century ago was a basic parameterization of all other values in terms of gold, plus or minus some cost-of-carry fuzz. Thus gold was the starting point for speaking about valuation: It provided a basic balance point. Gold was recognized as underlying currency only because enough people viewed it as such. This assignment of value is no more or less fragile than anything else. The gold standard is dead.

The monetary standard we have now is much more complicated and beautiful: It's like a Caribbean colony of jellyfish with sunlight shining through them as swimmers pass underneath. The arbitrary nature of valuation is now explicit and breathtakingly fluid. Everything changes in a day: yen valuation, U.S. dollars (USD), Canadian dollars (CAD). The starting point is the valuation of one currency to other currencies. It is remiss to call this system fragile: Jellyfish like this can kill a human being in a matter of seconds with one sting.

The system's dangerous sting is its complexity and interconnectedness. Complex adaptive systems are volatile, and the volatility causes instabilities in other things, such as labor and capital markets. Central banks have created a "bend but don't break" kind of stability through currency swaps. Currency swaps fix valuation between currencies on a relative basis because the most interconnected central banks also have the most freedom to use the printing press (see Figure 1.1).

This system is robust because it enables variance reduction without excessive rigidity. The extent of the network itself makes it robust. However, if one of the central nodes dies (e.g., USD, EUR, ECH, or JPY), then every node dies. Currency swap arrangements hold the world together.


THE PATH OF LEAST RESISTANCE IS SHARED SACRIFICE

Everyone knows a busted Treasury market when the economy is on life support would be more than bad. But it isn't hopeless. Default doesn't necessarily mean that the debtor summarily pays nothing. In fact, such a case is extremely rare. It's just not how things work.

In default, both debtors and creditors must absorb costs. This is especially true in the case of sovereign default. There has to be hope of getting out from under a mountain of debt before a population will agree even in theory to years of high taxation. And to prevent societies from unraveling, austerity cannot completely absorb the cost. Creditors, who must always be prudent of risk, should not be rewarded with a bailout. At the same time, creditor haircuts so extreme that they are perceived as theft leave everyone worse off.

Moderation almost always works out for the best. It's messy, confusing, and unfair to everyone. But it works. There is a clear symmetry in this middle path: Debtors and creditors share the pain. Debtors take steps that make them financially sound, creditors take haircuts to make this possible, and everybody else stays out of it.

In case of corporate default, time and due process convert debt into equity and enable credible restructuring in an orderly way. This concept is deep and shouldn't be trifled with by fools. Law is not something artificial or imposed. It is the product of natural selection because it has stood the test of time and is inherently capable of change. Government breaking these rules is cheating that distorts risk perception among debtors and creditors by applying guarantees. Markets work well when risk is understood. A market where debtors and creditors both have claim to a guarantee is the theater of the absurd.

Too much debt and too much capacity mean that the endgame of deleveraging is wealth destruction. The way out is wholly unconnected to theory or policies. It is decentralized. Millions of complicated adaptive families acting in their own best interest determine reality. Not Bernanke and not Goldman Sachs.

In nature, the lucky thrive, which is the strongest case for diversification out there. The majority survive, wiser and poorer for the experience. The unlucky get crushed.


HUMPTY-DUMPTY WAS PUSHED: HAIRCUTS AND AUSTERITY

Let's look at Latvia's recent situation because Latvia's problem is the global problem: a massive run-up in private-sector debt that led to a massive out- scaling of productive capacity (see Figure 1.2). For Latvia, it wasn't a government problem. Government debt went from frugal to prodigal because it was the only thing keeping society from coming apart at the seams. Meanwhile, the private sector is in full debt-reduction mode.

The Latvian tail-risk killer objective of LT/EUR stability implies that adjustment comes via the labor market and not inflation. Cutting the peg and devaluing the currency imply that savers and currency longs take the brunt of the pain. Either way, the result of adjustment is income reduction. The world is in the process of figuring out how the costs will be shared among creditors and debtors—the mix of haircuts and austerity. How it plays out in Latvia may be prophetic.


THE REALITY OF LOSS IS UNAVOIDABLE

The only workable remedies are organic ones: They are robust to specific circumstance, hopefully gradual, and the winners of natural selection against alternatives. However, there needs to be some symmetry in the inevitable restructuring, and this is where government can play a role—to assist in making adjustment gradual and ensuring that both debtors and creditors absorb costs. Push too hard, and the whole system will crash. Successful debt restructuring enables the survival of debtors and enforces to a degree the rights of creditors.

This is not sunshine and rainbows. Haircuts can be disguised as an extension of maturity, lower interest rates, or inflation, but they leave stinging damage that won't be forgotten the next time. Government extraction of high taxes from the profitable and the poor alike leaves citizens with difficult choices about how to survive without government assistance. The elderly eat grass soup gathered from their backyards. Stoical wives make hard evening decisions about who to spend the night with so as to feed their children. Jobless husbands are quiet and numb about these things.

Take note: All those sure of those hyper- and über-outcomes: Reality is more dreary and colorless than some blaze of glory on the way to hell, but it grinds you into dirt like nothing else. Policy fixeruppers: Be careful what you wish for. You never know when total failure will strike.

Such failure can show up when you least expect it, as demonstrated in Figure 1.3.

Central bankers, within certain parameters, have latitude to affect exchange rates. The relationship can look very predictable and controlled until a critical point is reached. Then all bets are off on what happens. A currency can go from a medium of exchange to strips of paper very quickly indeed.


(Continues...)


Excerpted from TAIL RISK KILLERS by Jeff McGinn. Copyright © 2012 by Jeff McGinn. Excerpted by permission of The McGraw-Hill Companies, Inc..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Meet the Author

Jeff McGinn serves as Head of Analytics at VHQC Consulting, an operational risk management and information management company. He has more than twenty years of experience in unlocking the elusive nature of risk, data analysis, and statistical modeling for such companies as Citibank, The Associates Financial, and a variety of Fortune 500 companies.

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