Readings: Risk vs. Uncertainty, Participatory Notes
A couple of reads worth you time:
* “Interdisciplinary Perspectives on Risk” by Michael Mauboussin of Legg Mason, posted at Michael Covel’s blog.
– Risk describes a system where we don’t know the outcome, but we do know what the underlying probability distribution of outcomes looks like.
– In contrast, uncertainty reflects a situation where you don’t know the outcome, but you also don’t know what the distribution of the underlying systems looks like.
– And real trouble arises when we model uncertain systems using the mathematical tools of risk. Yet this is precisely what many people do in financial markets …
* “Just why Participatory Notes attract such strong views”, by Sucheta Dalal
– It is estimated that over Rs 40,000 crore of PNs have been issued abroad by foreign brokers and are actively traded in some markets.
– From just around 15 to 20% of net FII inflows coming through PNs in 2002-03, the figure rose to 47% in April last year and jumped further to 52% in March 2006.
– The biggest beneficiaries of our bad policies are indeed foreign banks and intermediaries who earn hefty fees for channelling this money through appropriate vehicles and concealing true ownership.
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September 4th, 2006 at 5:45 pm
Thanks for the link to the Mauboussin paper. He is usually good. The reason options are so hard to model accurately is the imbedded assumption of lognormal ditribution of prices is attempting to model uncertainty with risk logic. Trillions of dollars of derivatives are traded worldwide with probabilities resting on an esoteric but fundamental flaw.
September 5th, 2006 at 7:48 am
Bruce,
Indeed. This anomaly has been repeatedly pointed out by Nassim Taleb, of “Fooled by Randomness” fame. His strategy of buying out-of-the-money calls & puts is essentially a bet that prices are NOT distributed normally, and that events like LTCM occur much more frequently than one would think.