Thursday, October 18, 2007

Risky Business

August this year was a nightmare month for the markets. The focal event, the collapse of the U.S sub-prime housing sector- a proverbial house of cards whose  fall many were predicting for months.

A constellation of after-effects and recalibration followed: major lending institutions withdrew into risk aversive shells; A credit crunch required intervention by the Federal Reserve. Bailouts of large failed Mortgage institutions and the ongoing efforts at injection of liquidity into a congealing market. Some stability was restored but there's continued talk of a recession looming as the long term adjustments occur and  their effects are felt across world markets.

Much of the blame for the sub prime fiasco is directed at the use of derivatives to leverage investment risk in a way many claim lost sight of common sense.

 The  complexity of interrelated world markets is dificult to express even for the most advanced. Bryant Urstadt
underlines this  idea yet still sheds light in a lucid article in Technology Review on the excesses that fueled the collapse of the Sub Prime Housing market.

He gives a sense of the role that Quants - the gifted financial engineers that direct international finance and investment today - played in pushing the statistical envelope in the use of derivatives to leverage risk. The approach used based on ever refined algorithms and driven by increasing computer processing power Urstadt says failed for the sub prime housing collapse for two possible reasons. One, that the leveraging of risk did not account for outlier events, rare unpredictable occurrences that threw off the previous assumptions on which the algorithm based investments were predicated and caused a domino effect collapse of their constructs. Two, that the algorithms themselves lost their viability, a feature of increasingly complex world markets where the shortening half lives of useful algorithms has become a built- in inevitability .

The article comes off as less an indictment of the failings of the work of Quants and more an expression of the increasingly complex nature of their aspiration: to find predictable patterns in the market.

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