Does Not Compute - washingtonpost.com

Does Not Compute - washingtonpost.com:

"Lenders of Sowood Capital Management learned recently that the prices of senior and junior debt don't, in fact, always move in the same direction in the midst of a liquidity crisis. And investors in Campbell & Co. learned that the model investing their $11 billion never imagined that the yen carry trade might unwind at the same time as a stock market downturn. The secret trading strategies of a number of 'quant funds' were foiled by the fact that the other funds had pretty much the same strategies. Now that the failure of some of these models has caused huge trading losses, there is concern that turmoil on financial markets might spill over into the real economy. Not to worry, assures the Federal Reserve, citing its economic forecasting models."

Comment: First lesson of modeling is to get the theory right. (Then you want to get the data and the implementation right, then you want to be sure the users understand the use and limitations of the model.)

In The (Mis) Behavior of Markets: A Fractal View of Risk, Ruin And Reward, Benoit B. Mandelbrot points out that stock markets do not follow the Gaussian distribution, and that extreme events (price increases or decreases) are more common that the Normal Distribution would predict. Since investors make or lose lots of money in days of extreme volatility, I assume those are the days that the models are most important. They are also the days when the assumptions (such as that of the Gaussian distribution) on which models are built are most likely to be wrong, or at least seriously challenged. JAD