Economics and similar, for the sleep-deprived

A subtle change has been made to the comments links, so they no longer pop up. Does this in any way help with the problem about comments not appearing on permalinked posts, readers?

Update: seemingly not

Update: Oh yeah!

Tuesday, October 07, 2008

A few suggestions for journalists and bloggers

Now 'tis the season for writing pieces about "How we got into this crisis", apparently. Can I just suggest that the following two practices do not make you look as clever as you think they do? First, writing a laundry list of behavioural-economics tics and jargon terms, each followed by a speculative just-so story about how this might have made people create a bubble. Offenders on this one know who they are. And second, references to "naked puts", "short volatility" or worst of all, the appropriation of Andrew Lo's "Capital Decimation Partners" example.

At slightly more length on this one - Lo made good use of it in his book on hedge funds (which someone sent me a review copy of, but neglected to include a slip saying why they were sending me it or where I was meant to review it, so thanks but sorry). And his use of the example was sensible. But it was so damnably catchy that it's been appropriated by a lot of people who seem to think that it has much more explanatory value than it does, and particularly that it can be used to justify a whole lot of poor-man's-Nicholas-Taleb warblings about the nature of risk.

Look at it this way. An insurance policy is a put option and vice versa (viz; car insurance is the option to sell a wrecked car for the price of a new one; conversely a FTSE100 put with a strike of 5000 is an insurance policy against the FTSE falling below 5000). Any insurance company in the world is in the business of writing naked puts, and hoping to collect the premiums without having a catastrophic claims experience.

And every insurance company in the world (apart from a few oddball runoff situations which have more capital than total claims exposure) has a positive probability of ruin (which, via the gambler's ruin theorem, means a certainty of ruin in finite time). The Capital Decimation Partners example is just the rediscovery of the fact that an insurance portfolio has positive probability of ruin. Insurance is a very profitable business that sometimes blows up; ask Warren Buffet, who writes fucking loads of insurance (and particularly, more than a little bit of tail risk big ticket reinsurance).

I don't know what you think, but personally (and this is a criticism of Taleb's work too, on some occasions but not others) I think that if you've got a theory of finance which could be used to prove that all insurance everywhere is a mirage, a piece of financial charlatanry which can't possibly work, then you're not actually contributing much to the discussion. The point of Lo's CDP example was that he created a specific structure of put-writing which was reasonably well calibrated to some real-world hedge fund return series, and which blew up under particular conditions of interest. Stripping the example of its numbers and just using it as a general sermon on "oooh, those people, eh, they take risks they don't understaand!" is missing the point totally.

One can certainly argue about whether any particular risk-taking enterprise was under- or over- capitalised, under- or over-diversified, or for that matter whether its risks are usefully modelled by analogy to an insurance portfolio. But simply pointing out that an insurance office has positive probability of ruin, then sitting back stroking your chin and saying "see, that's what it's really all about! Time to ruin is finite! Why don't the policymakers do something about that!" is the sort of thing that will hurt your reputation with me for knowing what you're talking about. This is particularly irritating for me, as it's been used by a lot of people who should know better, as well as the usual run of suspects who had no credibility with me anyway.
14 comments this item posted by the management 10/07/2008 12:37:00 AM

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