A New Risk Management Model for Wall Street

By Rickards, James G. | The RMA Journal, March 2009 | Go to article overview

A New Risk Management Model for Wall Street


Rickards, James G., The RMA Journal


Wall Street's risk management paradigm is a failure, says this observer, who argues that it should be replaced with an empirically robust model based on nonlinear complexity and critical-state dynamics. A clearinghouse for over-the-counter derivatives would improve transparency and manage failure in ways that can leave the system far healthier while avoiding systemic collapse.

Financial economics, over the past 50 years, has specialized in quantitative analysis of the problems of asset pricing, asset allocation, and risk management. Its contributions have been voluminous, leading to the creation of derivative products and enormous expansion of the markets in which those products are traded. Key contributions have included the Black-Scholes options pricing formula and the capital asset pricing model.

The general equilibrium paradigm that resulted underlies these developments and is based on two hypotheses:

1. The efficient market hypothesis (EMH): All available information is fully and rationally incorporated into market prices that move from one level to another based on "new" information without reference to the past. Therefore, no individual analysis can outperform the market since all insights are effectively "priced in."

2. Gaussian or "normal" distribution of price movements: Small fluctuations are common and extreme events are proportionately rare, with the overall degree distribution of such events falling in the familiar "bell curve" shape associated with random phenomena. In the late 1980s, substantial doubt began to emerge about this intellectual edifice. These doubts arose both deductively as the result of the new science of nonlinear physics, and inductively as the result of numerous empirical observations that failed to confirm either EMH or the Gaussian degree distribution.

In effect, a paradigm shift was under way in which the influence of behavioral economics, fractal geometry, complexity theory, heuristics, and related fields converged to demonstrate that not only did the general equilibrium paradigm fail to describe the reality of capital markets, but a more robust paradigm with powerful explanatory ability was waiting to take its place.

Extreme Events

The empirical failures of the general equilibrium paradigm are well known. Consider the following:

* The stock market crash of October 19, 1987, when the market fell 22.6% in one day.

* The "Tequila Crisis" of December 1994, when the Mexican peso plummeted 85% in one week.

* The Russian financial crisis and the failure of Long-Term Capital Management, a hedge fund, in September 1998, which caused the capital markets to almost cease functioning.

* The March 2000 dot-com collapse, during which the NASDAQ fell 80% over 30 months.

* The 9/11 attacks, after which the New York Stock Exchange closed and the value of its shares dropped 14.3% in the week following its reopening.

Of course, to this list of extreme events must now be added the financial crisis that began in July 2007. Events of this magnitude should, according to the general equilibrium paradigm, either not happen at all (because "rational" buyers will seek bargains once valuations deviate beyond a certain magnitude) or happen perhaps once every 100 years (because standard deviations of this degree lie extremely close to the x-axis on the bell curve, which corresponds to a value close to zero on the y-axis--that is, an extremely low frequency event). That all of these extreme events took place in just over 20 years is completely at odds with the predictions of stochastic methodology in a normally distributed paradigm.

Practitioners treated these observations not as fatal flaws in the general equilibrium paradigm, but rather as "anomalies" to be explained within the framework of the paradigm. Thus was born the "fat tail," which is simply an embellishment on the bell curve such that after approaching the x-axis (the extreme low frequency region), the curve "turns upward" again to intersect data points representing a cluster of highly extreme, but not so highly rare, events. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

A New Risk Management Model for Wall Street
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Author Advanced search

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.