Fri, May 29, 2009 - Page 9 News List

Predicting the unpredictable to assess the risk of a cataclysm

Analyses incorporating a ‘fat-tailed’ expected tail loss predicted last year’s market shock while other analysts were blissfully unaware, a statistician claims

By Jane Baird  /  REUTERS , LONDON

Professor Zari Rachev scorns the idea that market cataclysms cannot be forecast. He says his statistical models have predicted them, and his customers agree.

His daughter is now president of New York-based company FinAnalytica, which uses his models to provide investors and risk managers with a risk indicator that takes into account the worst-case scenarios.

As those who have so far survived the financial crisis pick over the wreckage to develop enhanced predictors of market risk, Rachev’s are among the offerings for people who believe statistical models can help.

“This past year was very important for us, because it validated everything that we worked for,” Boryana Racheva-Iotova told reporters by telephone from Bulgaria.

Her firm’s risk measure, “fat-tailed” expected tail loss or ETL, gave investors advance notice of a sharp fall in the Dow Jones Industrial Average among other markets: the Dow fell from a life high in November 2007 to a 12-year low in March this year, sliding sharpest after Lehman Brothers failed in September last year.

Fat-tailed ETL builds on the statistical phenomenon popularized by former options trader Nassim Nicholas Taleb’s focus on the massively unexpected.

Think of a bell curve on a statistician’s chart that reflects “normal distribution.” It is tall and wide in the middle — where most events fall — and drops and flattens out at the edges, where fewer things happen, making a shape on a graph like a bell. When the edges or tails swell, instead of nearly vanishing, they are called “heavy” or “fat.”

Streams of financial commentators have over the past year reveled in a desire to present the crash as coming out of the blue to math whizzes paid a fortune to study the statistical stars and presage such events.

But Rachev is one of those who say they saw it coming — because his models took the worst possible events into account.

DEPARTING FROM VAR

In the case of the Dow Jones index, his fat-tailed expected tail loss — a measure of the potential daily average loss in the worst 1 percent of scenarios — gave investors notice of rising risk.

Boston-based Henderson Capital Management, which does not disclose its funds under management, said it used FinAnalytica models to help identify investment funds with significant downside risk through last year.

“Some of these managers subsequently suffered large losses,” managing partner Mark Pearl said in a statement. One is now closing down, he added, declining to name it.

With the Dow Jones in the three years to late 2006, the fat-tailed ETL was below 2 percent, but it started to rise in 2007 to 4 percent in March, then 8 percent in April last year and 10 percent in mid-September last year.

By contrast, a typical Wall Street indicator that takes into account all cases but the worst 1 percent — known as value at risk (VAR) 99 — was signaling potential daily losses of no more than 2 percent until April last year and 5 percent in late-September.

Racheva-Iotova highlights the gap between the two indicators from late 2006 to mid-September last year.

“Now consider a market that understands the extreme risk for a key market driver such as the Dow Jones is in fact 40 percent higher for a period of more than a year and a half,” she said, implying investors would have been much more cautious.

London-based Aviva Investors, with £236.5 billion (US$359.6 billion) of assets under management as of the end of last year, started using the model two years ago.

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