(A) I suppose that the first lesson from talking to people about Riccardo Rebonato's The Plight of the Fortune Tellers is how foolish we academics are in thinking that there are things that go without saying: a great deal of the very large value of the book comes in saying things that, when I would say them in academic seminars, would be followed by somebody saying "But of course that goes without saying." The biggest example is Rebonato's hammered-home point that the 99.9% value-at -risk for a weekly return distribution cannot be determined. You would need 200 years of data from an unchanging return distribution before you could expect to have ten observations above the 99.9th percentile.
We academics say: of course. You cannot estimate the tails: they are tails. What 99.9 VaR, 1000-year flood, and their cousins mean is that you (a) took the standard deviation in the normal-time non-tail data you observed, and (b) multiplied it by 3.3. To call it the "thousand observation" level does not mean it is a one-in-a-thousand chance because the central limit theorem does not help you out in the tails. But talking to non-academics who have read this book I have found that they feel betrayed by the idea that a breach of the 99.999 weakly VaR can take place much more often than once every 2000 years--it is, after all, only 5.1 times the normal weekly change as defined by the standard deviation.
So: things that are to without saying should instead be said: as often as possible.
(B) I do think Rebonato has a tendency to throw the baby out with the bathwater. The tools of modern finance are very useful in dealing with one kind of risk: that associated with frequently-repeated transactions in normal times. Then the central limit theorem is your best friend, and the tools are wonderful. But there are a number of ways things go wrong:
- When transactions are not frequently-repeated enough so that you do not learn that your model is wrong, and you then discover that you were trading against somebody who had a much better mode of the situation.
- When for exogenous reasons times stop being normal, and you wind up in the tails.
- When you and your friends and your peers through your own actions create abnormal times.
These are three very different cases that deserve very different handling, but Rebonato runs them together...
(C) The four-part classification of transactions:
- Sold lottery tickets
- Bought insurance
- Sold insurance
- Bought lottery tickets
is very useful, and I wish that he had expanded on it more.
(D) The Greenspan quote:
the management of systemic risk is properly the job of the central bank. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed, central banks, by their existence, appropiately offer banks a form of catastrophe insurance against such events...
Is true but incomplete. Banks should carry out their operation anticipating rescue by the central bank from systemic risk. But banks need to take care that they do not by their actions greatly multiply the systemic risks that otherwise exist.
(E) All in all, a highly recommended book.
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