One gaffe these folks make is believing how deeply randomness is a part of markets. Take the popular phrase "fooled by randomness" and it's discussion in this thread. Even Geometric Brownian Motion's application to Finance for that matter is a theory...not fact What ever happened to prices and returns being determined by decisions, namely good management and stable investment. And what about Fed policy, international trade agreements, tax policy etc...Are those R.V.s? No offense to academia, as I used be apart of it, but just because someone puts an interesting title on a book, uses some elegant theory and yet turns a blind eye so they can make some pretty gross assumptions to get to their "elegant" theory / model doesn't mean it's gospel. It just means they have some knowledge and found a way to put a novel twist on it to sell a few books. Sacrificing complexity to obtain an elegant closed form solution is definitely overrated. Current economic crisis case and point!
Wait a sec, but that's exactly the charge that NNT levels at the academics? Are you now accusing him of doing the exact thing that is so anathema to him? dtrader, Swan Noir: as far as I can tell you're saying the same thing. Point is that wherever the current models' problems exist, whether it's the analytical approximations or the ability to extract signal from the noise, I just don't see the reason to assume that we're never going to be able to do any better. To me that's what NNT's rants boil down to, which is why I refuse to take him seriously.
This is a gross oversimplification. A couple of things: 1 - He has plenty of prescriptions. One of them, which popped up in The Black Swan book itself, was the suggestion that very large financial companies operating in a globalized environment were inherently dangerous. This was written before the crisis, by the way. As Christopher Caldwell observes in today's FT: As of now, we have large zombie banks whose employees now know they are government bureaucrats, but who still continue to act as if they're not. Obviously, this needs to be stopped. 2 - He is skeptical even of distributions that take into account fat tails, because he figures we may be imposing a structure and a limit on something that inherently doesn't have one. His approach to the markets incorporates this, and is surely a prescription. Scholes and Merton, when they blew up in 1998, nearly took the financial world with it. I don't know how well Taleb does, but I've never seen his name mentioned as a bailout recipient. That surely scores one for him.
In this paper we explain how a plain vanilla and binary credit default swap can be val- ued assuming no counterparty default risk. Like most other approaches, ours assumes that default probabilities, interest rates, and recovery rates are independent. Unfortunately, it does not seem to be possible to relax these assumptions without a considerably more complex model. However, we are able to reach some general conclusions about the impact of the assumptions on CDS valuations. http://www.rotman.utoronto.ca/~hull/DownloadablePublications/CredDefSw1.pdf So is this saying the model for credit default swap has nothing in that model for a counterparty risk? That model is what financial people use, and it only will work if the counterparty does not default? If that is what they are saying, then a black swan is not what happened to the financial world.
Finally someone who understands this because neither Taleb nor the majority of the posters here understand it. What happened was not a pricing issue but a counterparty issue. Counterparty default is not accounted for in pricing, that would be silly. It is like ES prices changing depending on who buys or sells a contract. If there is possibility of counterparty default you simply do not trade unless they post sufficient margin, and this is exactly what the organized exchanges manage. The problem with the crisis was that these OTC counterparty agrreements were not monitored by a central exchange or Bank. It was not CAPM, or anything related to that thatTaleb and others, usually cranks, think it did the damage.
So they make a big bet with NO enough money to pay that bet if they lose. (No margin call) Because they think they pass a risk, or dilute a risk with swaps for swaps for swaps?
Damn impressive thread. You can not know all of the variables that effect your trading environment so what is the solution? Think about how you can control the variables in your trading/charting environment or how you view your trading environment. Someone here turned me on to constant volume bar charting a few years ago and it has made a huge difference in my consistent profitabillity. It was like I had suddenly been able to calm any chart I applied them to.
It just irks me when people say that market movements are random, as nothing could be further from the truth. And for people to assume CP risk isn't handled is also ludicrous. What do you think collateral management departments do all day long...play solitaire? Just because some dumb funds treated this operations task as of little account doesn't mean other firms are dumb. If the counterparty doesn't post collateral when M2M moves against them or they are downgraded then it's simple...unwind or novate the contract. Not to mention if an institution wants to enter position A with X notional, they split up the order and put it on with many firms to diversify. Risk management and collateral management aren't unique to Finance, If you have a vendor or a customer who are in danger of not delivering you always have the option to take your business elsewhere.