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Sunday, July 5, 2009

Read Taleb’s Black Swan?....twice?… now what?

The Black Swan is an enthralling and instructive read for anyone concerned about future risk; such as any member of the Global Credit Management Group. A thorough study of this work and its predecessor Fooled by Randomness is highly recommended. Nassim Nicholas Taleb (NNT) draws together a large number of references and anecdotes to illustrate his points. He repeatedly attacks the received wisdom of those who model the future and who, being lulled into a false sense of security by the elegant mathematics of their models, are repeatedly surprised when the future does not adhere to their script.

In essence NNT persuades the reader that the most impactful social and technological changes – the changes that will drastically alter the course of future history - cannot be predicted since they are ‘unknown unknowns’. Such events – which he calls Black Swans – will happen for the first time so cannot be imagined in advance, and cannot be predicted by models that extrapolate forward the past. The past cannot be a basis on which to predict the future; ask any turkey just before the butcher’s cleaver falls if he thought his today would be any different from the preceding 1000 days when he ate heartily and potted around a garden or dozed in the sunshine….

With such thoughts in mind, NNT is particularly critical of the use of past trends and volatility statistics to model future risk probabilities. The omnipresent use of Value at Risk (VaR) and Credit Value at Risk (CVaR) calculations to ‘predict’ future losses, with 95% or 99% confidence, NNT shows to be particularly dangerous; as has proved to be the case time and again. Yet the majority of academics and the decision makers they train persist in the use of VaR and CVaR - by inference bowing at the Alter of the ‘bell curve’ – because ‘The demand for certainty is one which is natural to man…’ (Bertrand Russell) even if that certainty is built on mathematical models that cannot predict pivotal events. Thus building on sand, trusting in false predictors, all of the unconverted – those who chose to ignore BenoĆ®t Mandelbrot’s theories as expounded by NNT in The Black Swan – created the instruments and conditions that caused the global financial firestorm (Credit Crunch) that followed the collapse of US house prices and the bankruptcy of Lehman Brothers.

NNT refers to the ‘bell curve’ as ‘that great intellectual fraud’.

This is all very interesting however the burning question after reading this seminal work is; what does it mean for someone in the business of Credit (Performance and Payment) Risk Management?

Read the full article at this address

Ron Wells