The World According to Nassim Taleb https://merage.uci.edu/~jorion/oc/ntaleb.

htm

The World According to Nassim Taleb

© 1996--Derivatives Strategy

Derivatives Strategy: What problems do you have with financial engineering?

Nassim Taleb: I disagree with such an approach in financial risk management. Some folks looked at the
literature and saw differential equations and said "Gee it's like engineering". Engineering relies on models
because you can capture the relationships in the physical world very well. Models in the social sciences serve
a different purpose. They make strong assumptions. Economists have known for a long time that math in
their profession has a different meaning. Its just a tool, a way to express yourself.

DS: So real engineering could lead to a bridge that you could reliably drive cars across. But modeling in
financial engineering isn't certain enough to run a portfolio...

NT: Exactly. In finance, you are not as confident about the parameters. The more you expand your model by
adding parameters, the more you become trapped into an inextricable apparatus of relationships. It is called
overfitting.

DS: What do think of value at risk?

NT: VAR has made us replace about 2500 years of market experience with a covariance matrix that is still in
its infancy. We made tabula rasa of years of market lore that was picked up from trader to trader and
crammed everything into a covariance matrix. Why? So that a management consultant or an unemployed
electrical engineer can understand financial market risks.

To me, VAR is charlatanism because it tries to estimate something that is not scientifically possible to
estimate, namely the risks or rare events. It gives people misleading precision that could lead to the build up
of positions by hedgers. It lulls people to sleep. All that because there are financial stakes involved.
To know the VAR you need the probabilities of events. To get the probabilities right you need to forecast
volatility and correlations. I spent close to a decade and a half trying to guess volatility, the volatility of
volatility , and correlations, and I sometimes shiver at the mere remembrance of my past miscalculations.
Wounds from correlation matrices are still sore.

DS: Proponents of VAR will argue that it has its shortcomings but it's better than what you had before.

NT: That's completely wrong. It's not better than what you had because you are relying on something with
false confidence and running larger positions than you would have otherwise. You're worse off relying on
misleading information than on not having any information at all. If you give a pilot an altimeter that is
sometimes defective he will crash the plane. Give him nothing and he will look out the window. Technology
is only safe if it is flawless.
A lot of people reduce their anxiety when they see numbers. They want a triple digit delta or gamma for
example, not taking into account that it is foolish to be precise with deltas when you don't even know the
parameters.
Before VAR, we looked at positions and understood them using what I call a non parametric method. After
VAR, all we see is numbers, numbers that depend on strong assumptions. I'd much rather see the details of
the position itself rather than some numbers that are supposed to reflect its risks.
Clearing firms understood that very well. Ironically, the stock market crash coincided with the discovery of
this so-called parametric system used to run the risks of option traders. In the old days, the clearing firms
looked at how many calls you were short and how many you were long and if you sold a lot of calls they
would get nervous and call you up and ask you to liquidate some of them. After they went to parametric

1 of 5 07-10-2020, 15:00
The World According to Nassim Taleb https://merage.uci.edu/~jorion/oc/ntaleb.htm

monitoring of option positions using second rate statistical methods, the options traders started building up
massive short put positions that, along with portfolio insurance, helped to accelerate the crash. Now they're
coming back to square one with their non parametric methods, particularly with the puts.

DS: Do you think the whole idea of trying to use statistics to model a particular distribution is fraudulent? Or
is it possible to come up with something approximating the truth?

NT: The problem we have with statistics is that although we know something about distributions, we know
very little about processes. A process is a distribution that has time in it and things change with time. People
look at fat tails and say, "We can simulate distributions with fat tails." But the reason distributions have fat
tails may be because these distributions don't have stable properties over time.

DS: VAR proponents will also admit that VAR doesn't work as well on something with an asymmetric
payoff...

NT: Yes, but any dynamic trading strategy by a leveraged investor that has a stop loss in it has an asymmetric
payoff and needs to be treated like an option. If I trade Deutsche Mark or bond futures with a stop loss, the
frequency of my losses will be greater than the frequency of my profits but the magnitude of my losses will
be smaller to compensate. It will look like a payoff of an option, and that's not captured by VAR. The VAR
assumes than traders are stuffed animals between two reports.

DS: Are you saying VAR can't be used to measure risks on a trading desk?

NT: The risks of common events perhaps, those that do not matter, but not the risks of rare events. Moreover
traders will find the smallest crack in the VAR models and try to find a way to take the largest position they
can while showing the smallest amount of risk. Traders have incentives to go the maximum bang because of
the free option they're granted.

DS: What free option is that?

NT:Most institutional traders don't pay for their losses. If you make a dollar, you get paid ten cents. If you
lose one dollar you pay zero. That obviously looks like an option payoff.
So let's say your trader trades two bonds of slightly different maturities. They're very close but because they
have illusory close maturities the position will not produce a big VAR number. Sometimes they are treated as
the same bond. The position, however, could easily bankrupt the company because of the sheer size that was
built on it. An institution just last month lost bundles because a trader built up massive positions in Bunds
against German swaps as their system, otherwise sophisticated, did not differentiate between them.

DS: What's going to happen if everybody in the financial system starts using VAR?

NT: VAR players are all dynamic hedgers and need to revise their portfolios at different levels. As such they
can make very uncorrelated markets become very correlated. Those who refuse to learn from the portfolio
insurance debacle do not belong to risk management.
In 1993 Hedge funds were long seemingly independent markets. The first margin call in the bonds lead them
to liquidate their positions in the Italian, French and German bond markets. Markets therefore became
correlated. Markets that were correlated became independent.
VAR is a school for sitting ducks. Find me a dynamic hedger who is a reluctant liquidator and I will front run
him to near bankruptcy.

DS: So one problem with VAR models is that they don't account for the fact that the market corrects for the
models that trades are based on.

NT: Bingo. Even more: Our perception of what's going on in the real world can hurt us simply because we

2 of 5 07-10-2020, 15:00
The World According to Nassim Taleb https://merage.uci.edu/~jorion/oc/ntaleb.htm

have to realize that we are the major players ourselves and we act according to our perceptions. In physics it's
called the Heisenberg uncertainty principle. In the social sciences its even more pronounced.
When people ask me what alternative to VAR I have to offer, my answer is: smaller leverage, less naive
diversification, less reliance on dynamic hedging.

DS: Are all correlations suspect?

NT: You can find a relationship between any two items if you look hard enough. It will be entirely spurious
and have no predictive power but you will find one. To give you an idea, you'll always find what we call data
miners who will show you that there is 100 per cent correlation between his great aunt's blood pressure and
the back month Nikkei volatility. When you're a trader you get a lot of calls from folks who found
relationships that can produce a 10 Sharpe ratio. That means it's almost impossible to lose money on the
trade. Sure enough, when you start trading you realize that the relationship was not there. Trading has less
biases than statistics.

DS: What are the most common mistakes you see traders and risk managers making?

NT: As a trader, my job is to understand biases and trade on them. There are all kinds of biases. The most
common is the small sample bias. Let's say you have 1 to 1000 odds you will come home every day with a
dollar and once in a while you lose $1000. Many traders show very steady incomes but they could be fooling
themselves because they don't have a long enough period of time to chart their performance. Their Sharpe
ratio will not be indicative. In option trading, there is a similar bias. Short premium option traders, typically
those who sell out-of-the-money options, are more likely to make money on a daily basis and then blow up.
Likewise the yield hogs, those traders who would take any risk for a few basis points. You can fool yourself
with your Sharpe ratios, and you can fool all of the financial engineers, but you can't fool an old Chicago
trader who went bankrupt twice.
Another bias is what I call the size bias. If you have twenty thousand traders in the market, sure enough you'll
have someone who's been up every day for the past few years and will show you a beautiful P&L. If you put
enough monkeys on typewriters, one of the monkeys will write the Iliad in ancient Greek. But would you bet
any money that he's going to write the Odyssey next? You know that because of the sheer size of the sample,
you're likely to find a lucky monkey once in a while. But the same applies to traders.
A third bias is the survival bias. Everybody will tell you that stock investing is a great idea because it's been
back-tested by some serious Guru and if you bought one share of some stock during the revolution you would
have owned the GNP of some banana republic. But you forget that your back testing is only on stocks that are
alive today and did not cover stocks in imperial Russia that a rational investor would have bought at the
beginning of the century. Many continental stocks were recycled into wallpaper. When you look at markets
you are only looking at the remnants, the parts that have survived. Or take real estate. People always say it
goes up. But that works only if you always bought in places that became fancy.

DS: So essentially, you'd like to replace statistical valuation that's at the center of most derivatives trading
with valuation that's more based on experience.

NT: You learn a lot about valuation from trading with other traders, by seeing what others give you and what
they take away from you. What they give is generally worth less, and what they take is worth more. Its sort of
like cars that are lemons. When you buy a lemon, only the seller knows it's a lemon. You need to drive it for a
while to know its a lemon. Its the same with options. You don't know an option is a lemon, but you have to
assume if someone is selling it you, you have a high probability of it being a lemon. Very often you won't
know the options value until you actually manage it for a while. Some options hedge very well and some
don't.

DS: Can you give me an example?

3 of 5 07-10-2020, 15:00
The World According to Nassim Taleb https://merage.uci.edu/~jorion/oc/ntaleb.htm

DT: Sure, take upside calls on the S&P. Retail investors tend to sell a lot of higher strike calls in equity
markets and buy a lot of lower strike puts. You look at the distributions and you assume you're being
compensated with the volatility differential buying higher strike calls and selling lower strike puts. But once
you start running it, you will notice that some undetectable behavior makes you lose money on the trade. And
your back-testing cannot fully detect that.
It's more intricate than it seems. It's not just the volatility of the upside or the downside, its the volatility
around a particular strike that has a large open interest. We call these sticky strikes. The markets tend to
compress in variation around these strikes. Good traders can sense that.
Also when you a stock warrant on an illiquid stock , you need to take into account that your own hedging will
reduce the volatility and stabilize the stock. That added to that of other dynamic hedgers.

DS: You left a job as the senior options at the Union Bank of Switzerland to go to Chicago and become a
floor trader. Why did you leave Wall Street? What did you think you were missing by trading from a screen
in New York ?

NT: I left Wall St. for the first time in 1991. I was obsessed with price formation. I couldn't understand from
the screen how prices were determined. It took me six months to be able to read prices in the pit. Locals
basically read information from the order flow and squeeze the weak party. There's always a pack five or six
dominating locals who abruptly change the prices, who bid a lot higher than the previous offer and have the
guts to do it and the rest of them follow.

DS: How did that knowledge change the way you trade when you went back to trading from a screen?

NT: It is the most enriching experience for a trader. I learned about market dynamics in my second sixth
months than from years on a desk. I learned that traders' income is not the bid-offer spread, but the micro-
squeezes that take place. Markets move from squeezes to squeezes. Traders make money on stop losses and
other free options. It made me interested with information economics.

DS: You're not ready to give up on all quantitative techniques. You were trained as a statistician. You don't
make wild speculative bets and I assume you try to hire traders who have some kind of quantitative skills.

NT: I have the following problem. Anytime I take a street smart kid with a strong Brooklyn accent and train
him or her in quant methods, I develop a wonderful quant trader who knows how to squeeze the sitting ducks.
When you take extremely quantitative trainees, particularly from the physical sciences, and try to make them
arbitrage traders, they freak out and become pure gamblers. They can’t see the edge and become the sitting
ducks. The world has too much texture than they can squeeze into the framework they're used to. I see a huge
incidence of pure speculative gambling on the part of these folks who are hired on the strength of their
knowledge of quantitative methods.

DS: How about risk managers? What do you look for in risk managers that you hire?

NT: I try to probe their minds to see what makes them tick. And I start quizzing them quite unfairly about
market history. I ask them about what happened to the correlation between bonds and mortgages on the day
when the stock market crashed. I quiz them about the gold rally in the early 80's. I test to see if they
intuitively understand squeezes. If they don't show any interest in data, in any true market history, I stop the
interview and send them home. To me it is extremely dangerous to have in such positions people who only
trust equations. You can’t get the edge if you just learn from your own mistakes. You need to learn from other
people’s mistakes as well and these are public information.

DS: Where do you think research in the financial markets is heading? What's valuable and what's not?

NT: Financial economics has been extremely successful at melding the math with economic insight. This is

4 of 5 07-10-2020, 15:00
The World According to Nassim Taleb https://merage.uci.edu/~jorion/oc/ntaleb.htm

providing traders with better understanding of derivatives pricing. My motto is that the markets follow the
path that hurts the highest number of dynamic hedgers. It was exciting to read a mathematical proof of it by
Grossman and Zhou in the latest Journal of Finance. We are having less success with the frenetic financial
engineering efforts, with a lot of mathematical acrobatics, but a hollow ring.

5 of 5 07-10-2020, 15:00
In Defense of VAR https://merage.uci.edu/~jorion/oc/ntalib2.html

In Defense of VAR
Philippe Jorion

© 1997--Derivatives Strategy

In a recent interview in Derivatives Strategy, Nassim Taleb delivered a blistering attack on value at risk
(VAR). The gist of the message was that VAR is utterly useless as a risk management tool, as is much of the
field of financial engineering. This view is somewhat unusual given the widespread interest in VAR. VAR is
now widely used by U.S. financial institutions. It will be extended further following the recent Securities and
Exchange Commission ruling that public corporations must disclose quantitative information about their
derivatives activity. All of this effort would be wasted if VAR was indeed useless.

In his discussion, Nassim Taleb brings up some important points, which are too often ignored and should be
re-emphasized. I want to take issue, however, with a number of other arguments, to which I turn first.

First, the purpose of VAR is not to describe the worst possible outcomes. It is simply to provide an estimate
of the range of possible gains and losses. Many derivatives disasters have occurred because senior
management did not inquire about the first-order magnitude of the bets being taken. Take the case of Orange
County, for instance. There was no regulation that required the portfolio manager, Bob Citron, to report the
risk of the $7.5 billion investment pool. As a result, Citron was able to implement a big bet on interest rates
which came to a head in December 1994, when the county declared bankruptcy and the portfolio was
liquidated at a loss of $1.64 billion. Had a VAR requirement been imposed on Citron, he would have been
forced to tell investors in the pool:

"Listen, I am implementing a triple-legged repo strategy that brought you great returns so far. However, I
have to tell you that the risk of the portfolio is such that, over the coming year, we could lose at least $1.1
billion in 1 case out of 20."

The advantage of such a statement is that this quantitative measure is reported in units that anybody can
understand--in dollars. Whether the portfolio is leveraged or filled with derivatives, its market risk can be
conveyed to a non-technical audience effectively.

It is fairly clear that, had such an announcement been made, investors would have been more careful about
investing in the pool (or would have disciplined Citron). In addition, it would have been harder for investors
to claim they were misled. Fewer lawsuits would have been filed. Perhaps other embarrassing debacles such
as Barings, Procter & Gamble or Gibson Greetings would have been avoided. Derivatives disclosure should
increase transparency and stability in financial markets.

VAR has other benefits, too. By now, all U.S. commercial banks monitor the VAR of their trading portfolios
on a daily basis. Suppose a portfolio VAR suddenly increases by 50%. This could be due to a variety of
factors. Market volatility could have increased overnight. Or, a trader could be taking inordinate risks. Or, a
number of desks could be positioned on the same side of a looming news announcement. More prosaically, a
position could have been entered erroneously. Any of these factors should be cause for further investigation,
which can be performed by reverse-engineering the final VAR number. Without it, there is no way an
institution could get an estimate of its overall risk profile.

The Orange County example, however, points out one of the limitations of VAR, which is inherent in the
definition. We would expect situations where the range of VAR is exceeded, for instance in 5% of the cases
using a 95% confidence level. This was the case in Orange County, for instance, where a particularly volatile
bond market led to a loss of $1.6 billion, in excess of the VAR estimate. Practically speaking, there is no way

1 of 3 07-10-2020, 14:58
In Defense of VAR https://merage.uci.edu/~jorion/oc/ntalib2.html

to provide an estimate of the absolute worst outcome (in the same sense that the tails of continuous
probability distributions are unlimited.) Nor should we expect an institution to be protected against all
possible losses, however unlikely. As Chairman Greenspan stated, "when market forces... break loose of
economic fundamentals,... sound policy actions, and not just bank capital, are necessary to preserve financial
stability."

Still, VAR must be complemented by stress-testing. This involves looking at the effect of extreme scenarios
on the portfolio. This is particularly useful in situations of "dormant" risks, such as fixed exchange rates,
which are subject to devaluations. Stress-testing is much more subjective than VAR because it poorly
accounts for correlations and depends heavily on the choice of scenarios. Nevertheless, I would advocate the
use of both methods.

A second misconception raised in the discussion is that VAR involves a covariance matrix only and does not
work with asymmetric payoffs. This is not necessarily the case. A symmetric, normal approximation may be
appropriate for large portfolios, where independent sources of risk, by the law of large numbers, tend to
create normal distributions. But the delta-normal implementation is clearly not appropriate for portfolios with
heavy option components, or exposed to few sources of risk, such as traders' desks. Other implementations of
VAR do allow asymmetric payoffs.

A third, more specific, point is that the VAR approach is useless because volatilities and correlations change
over time. This is debatable. Even when changes occur, the degree of precision in daily volatilities is much
higher than that in expected returns. Traders routinely take positions based on views that are even less
reliable than risk measures. It is hard to tell whether traders are right or wrong; we do know, however, when
they are taking large risks. Also, we have successfully learned to model volatilities that change over time
(e.g. using GARCH models and related acronyms). Even better, we can use risk measures implied from
option data, which are the best forecasts one could expect. It seems to me that our goal should be to try to
improve our forecasts of risk, instead of discarding the whole VAR approach and relying on "market lore."

Nassim Taleb also discusses a more general issue, which is that of the usefulness of scientific improvements.
His point is that VAR is useless because it is not perfect (unlike measures in the physical sciences).
Admittedly, VAR is not perfect. However, our world is constructed by engineers, not physicists. And
engineering has been described as the "art of the approximation." The same definition applies to VAR. In
fact, risk managers are less concerned about precision than traders who have to price derivatives. The advent
of derivatives has been compared to allowing us to drive at a faster speed in financial markets. VAR is like a
wobbly speedometer. Even so, it gives a rough indication of speed. Derivatives disasters have occurred
because drivers or passengers did not worry at all about their speed. Of course, there can be other sources of
crashes. Like blown tires, for instance. Such accidents can be compared to operational risks, against which
VAR provides no direct protection. Still, a wobbly speedometer is better than nothing.

Finally, let me turn to one issue on which we agree (at last). Nassim Taleb points out an important problem,
what I would call the "VAR dialectic" issue. If a risk manager imposes a VAR system to penalize traders for
the risks they are incurring, traders may have an incentive to "game" their VAR. In other words, they could
move into markets or securities that appear to have low risk for the wrong reasons. For instance, currency
traders in 1994 could have taken large positions in the Mexican Peso, which had low historical volatility but
high devaluation risk. Or, traders exposed to a delta-normal VAR could take short straddles with zero delta
(like Baring's Leeson); this position appears profitable, but only at the expense of future possible losses
which may not captured by VAR.

This response explains why the actual benefits from technical innovations are generally less than hoped for.
Going back to the driving example, the addition of safety features such as anti-lock brakes and airbags has
saved fewer lives than initially expected, because some drivers may be lulled into a false sense of safety.
Even so, the net effect of these innovations is beneficial. My car has both antilock brakes and an airbag.

2 of 3 07-10-2020, 14:58
In Defense of VAR https://merage.uci.edu/~jorion/oc/ntalib2.html

In the context of portfolio management, gaming by traders can be compared to the general problem of in-
sample portfolio optimization, which is well known to create optimistic views of risk. I fully agree that this is
a serious limitation of VAR. This is why risk management is not simply a black box, but a dynamic process
where a competent risk manager must be aware of the human trait for adaptation.

To conclude, it seems premature to describe VAR as "charlatanism". In spite of naysayers, VAR is an

essential component of sound risk management systems. VAR gives an estimate of the potential losses due to
market risks. In the end, the greatest benefit of VAR lies in the imposition of a structured methodology for
critically thinking about risk. Institutions that go through the process of computing their VAR are forced to
confront their exposure to financial risks and to set up a proper risk management function. Thus the process
of getting to VAR may be as important as the number itself. These desirable features explain the widespread
view that the "quest for a benchmark may be over".

________________________________________

Philippe Jorion is a Professor of Finance at the University of California at Irvine. He has a degree in the "the
art of the approximation" (i.e. engineering) from the University of Brussels, and an MBA and PhD from the
University of Chicago. He has published widely in academic and practitioner-oriented journals. His latest
book, "Value at Risk: The New Benchmark for Controlling Market Risks", was published by Irwin
Professional in late 1996.

3 of 3 07-10-2020, 14:58
Against Value at Risk https://www.fooledbyrandomness.com/jorion.html

Against Value-at-Risk: Nassim Taleb Replies to Philippe Jorion

Copyright 1997 by Nassim Nicholas Taleb.

Since then I have been calling Jorion a certified charlatan based on evidence from subsequent events.

Philippe Jorion is perhaps the most credible member of the pro-VAR camp. I will answer his criticism while
expanding on some of the more technical statements I made during the interview (DS, December/January
1997). Indeed, while Philippe Jorion and I agree on many core points, we mainly disagree on the conclusion:
mine is to suspend the current version of the VAR as potentially dangerous malpractice while his is to
supplement it with other methods.

My refutation of the VAR does not mean that I am against quantitative risk management - having spent all of
my adult life as a quantitative trader, I learned the hard way the fails of such methods. I am simply against the
application of unseasonned quantitative methods. I think that VAR would be a wonderful measurement if we
had models designed for that purpose and knew something about their parameters. The validity of VAR is
linked to the problem of probabilistic measurement of future events, particularly those deemed infrequent
(more than 2 standard deviations) and those that concern multiple securities. I conjecture that the methods
we currently use to measure such tail probabilities are flawed.

The definition I used for the VAR came from the informative book by Philippe Jorion, "It summarizes the
expected maximum loss (or worst loss) over a target horizon within a given confidence interval". It is the
uniqueness, precision and misplaced concreteness of the measure that bother me. I would rather hear risk
managers make statements like "at such price in such security A and at such price in security B, we will be
down $150,000". They should present a list of such associated crisis scenarios without unduly attaching
probabilities to the array of events, until such time as we can show a better grasp of probability of large
deviations for portfolios and better confidence with our measurement of "confidence levels". There is an
internal contradiction between measuring risk (i.e. standard deviation) and using a tool with a higher
standard error than that of the measure itself.

I find that those professional risk managers whom I heard recommend a "guarded" use of the VAR on
grounds that it "generally works" or "it works on average" do not share my definition of risk management.
The risk management objective function is survival, not profits and losses ( see rule-of-thumb 8 ). A trader
according to the Chicago legend, "made 8 million in eight years and lost 80 million in eight minutes".
According to the same standards, he would be, "in general", and "on average" a good risk manager.

Nor am I swayed with the usual argument that the VAR' s wide-spread use by financial institutions should
give it a measure of scientific credibility. Banks have the ingrained habit of plunging headlong into mistakes
together where blame-minimizing managers appear to feel comfortable making blunders so long as their
competitors are making the same ones. The state of the Japanese and French banking systems, the stories of
lending to Latin America, the chronic real estate booms and bust and the S&L debacle provide us with an
interesting cycle of communal irrationality. I believe that the VAR is the alibi bankers will give shareholders
(and the bailing-out taxpayer) to show documented due diligence and will express that their blow-up came
from truly unforeseeable circumstances and events with low probability - not from taking large risks they did
not understand. But my sense of social responsibility will force me to menacingly point my finger. I maintain
that the due-diligence VAR tool encourages untrained people to take misdirected risk with the shareholder's,
and ultimately the taxpayer's, money.

The act of reducing risk to one simple quantitative measure on grounds that "everyone can understand" it
clashes with my culture. As rule-of-thumb 1 from "trader lore" recommends: do not venture in businesses and

1 of 4 07-10-2020, 15:01
Against Value at Risk https://www.fooledbyrandomness.com/jorion.html

markets you do not understand. I have no sympathy for warned people who lose money in these
circumstances.

Praising VAR because it would have prevented the Orange County and P&G debacles is a stretch. Many VAR
defenders made a similar mistake. These events arose from issues of extreme leverage -and leverage is a
deterministic, not a probabilistic, measurement. If my leverage is ten to one, a 10% move can bankrupt me. A
Wall Street clerk would have picked up these excesses using an abacus. VAR defenders make it look like the
only solution where there are simpler and more reliable ones. We should not does not allow the acceptance of
a solution on casual corroboration without first ascertaining whether more elementary ones are available (like
one you can keep on a napkin).

I disagree with the statement that "the degree of precision in daily volatility is much higher than that
in daily return". My observations show that the one week volatility of volatility is generally between 5
and 50 times higher than the one week volatility (too high for the normal kurtosis). Nor do I believe
that the ARCH-style modeling of heteroskedasticity that appeared to work in research papers, but has
so far failed in many dealing rooms, can be relied upon for risk management. The fact that the
precision of the risk measure (volatility) is volatile and intractable is sufficient reason to discourage us
from such a quantitative venture. I would accept VAR if indeed volatility were easy to forecast with a
low standard error.

The Science of Misplaced Concreteness

On the apology of engineering, I would like to stress that the applications of its methods to the social
sciences in the name of progress have lead to economic and human disasters. The critics of my position
resemble the Marxist defenders of a more "scientific" society who seized the day in the '60s, who portrayed
Von Hayek as backward and "unscientific". I hold that, in economics, and the social sciences, engineering has
been the science of misplaced and misdirected concreteness. Perhaps old J.M. Keynes had the insight of the
problem when he wrote: " To convert a model into a quantitative formula is to destroy its usefulness as an
instrument of thought."

If financial engineering means the creation of financial instruments that improve risk allocation, then I am in
favor of it. If it means using engineering methods to quantify the immeasurable with great precision, then I
am against it.

During the interview I was especially careful to require technology to be "flawless", not "perfect". While
perfection is unattainable, flawlessness can be, as it is a methodological consideration and refers to the
applicability for the task at hand.

Marshall, Allais and Coase used the term charlatanism to describe the concealment of a poor understanding
of economics with mathematical smoke. Using VAR before 1985 was simply the result of a lack of insight
into statistical inference. Given the fact that it has been falsified in 1985, 1987, 1989, 1991, 1992, 1994, and
1995, it can be safely pronounced plain charlatanism. The prevalence of between 7 and 30 standard
deviations events (using whatever information on parameters was available prior to the event) can
convince the jury that the model is wrong. A hypothesis testing between the validity of the model and the
rarity of the events would certainly reject the hypothesis of the rare events.

Trading as Clinical Research

Why do I put trader lore high above "scientific" methods ? Some of my friends hold that [option] trading is
lab-coat scientific research. I go beyond that and state that traders are clinical researchers, like medical
doctors working on real patients --a more truth revealing approach than simulated laboratory experiments. An

2 of 4 07-10-2020, 15:01
Against Value at Risk https://www.fooledbyrandomness.com/jorion.html

opinionated econometrician will show you (and will produce) the data that will confirm his side of the story
(or his departmental party line ). I hold that active trading is the only close to data-mining free approach to
understand financial markets. You only have one life and cannot back-fit your experience. As a result,
clinical experiences of the sort are not just the best verifiable accounts of the accuracy of a method: they are
the only ones. Whatever the pecuniary motivation, trading is a disciplined truth-seeking proposition. We are
trained to look into reality's garbage can, not into the elegant world of models. Unlike professional
researchers, traders are never tempted to relax assumptions to make their model more tractable.

Option traders present the additional attribute of making their living trading the statistical properties
of the distribution, therefore carefully observing all of its higher order wrinkles. They are rational
researchers who deal with the unobstructed Truth for a living and get (but only in the long term) their
paycheck from the Truth without the judgment or agency of the more human and fallible scientific
committee.

Charlatanism: a Technical Argument

At a more philosophical level, the casual quantitative inference in current use is too incomplete a method.
Rule 1 conjectures that there is no "canned" standard way to explore stressful events: they never look alike
since humans adjust. It is indeed hard to conciliate standard naive inference (based on past frequencies) and
the dialectic of historical events (people adjust). The crash of 1987 caused a sharp rally in the bonds. This
became a trap during the mini-crash of 1989 ( I was caught myself ). The problem with the adjustments to
VAR by "fattening the tails" as an after-the-fact adaptation to stressful events that happened is
dangerously naive. Thus the VAR is like a Maginot line. In other words there is a tautological link between
the harm of the events and their unpredictability, since harm comes from surprise. As rule-of-thumb 2
conjectures (see Box), nothing predictable can be truly harmful and nothing truly harmful can be predictable.
We may be endowed with enough rationality to heed past events (people rationally remember events that hurt
them).

Furthermore, the simplified mean-variance paradigm was designed as a tool to understand the world,
not to quantify risk (it failed in both). This explains its survival in financial economics as a pedagogical
tool for MBA students. It is therefore too idealized for risk management, which requires higher moment
analysis. It also ignores the forays made by market microstructure theory. As a market maker, the fact of
having something in your portfolio can be more potent information than all of its past statistical properties:
securities do not randomly land in portfolios . A bank's position increase in a Mexican security signifies an
increase in the probability of devaluation . The position might originate from the niece of an informed
government official trading with a local bank. For having been picked on routinely traders (who survived the
sitting duck stage) adjust for these asymmetric information biases better than the "scientific" engineer.

The greatest risk we face is therefore that of the mis-specification of financial price dynamics by the available
models. The 2 standard deviations (and higher) VAR is very sensitive to model specification. The
sensitivity is compounded with every additional increase in dimension (i.e. in the number of securities
included). For portfolios of 75 securities (a small portfolio for a trading room), I have seen frequent 7
and higher standard deviation variations during quiet markets. Thus VAR is not adapted for the brand of
diversified leverage we usually take in trading firms. This risk I call the risk of incompleteness issue, or the
model risk. A model might show you some risks, but not the risks of using it. Moreover, models are built on a
finite set of parameters, while reality affords us infinite sources of risks.

Options may or may not deliver an estimation of the consensus on volatility and correlations. We can
compute, in some markets, some transition probabilities and, in some currency pairs with liquid crosses, joint
transition probabilities (hence local correlation). We cannot, however, use such pricing kernels as gospel.
Option traders do not have perfect foresight, and, as much as I would like them to, cannot be considered

3 of 4 07-10-2020, 15:01
Against Value at Risk https://www.fooledbyrandomness.com/jorion.html

prophets. Why should their forecast of the second moment be superior to that of a forward trader's future
price ?

I only see one use of covariance matrices: in speculative trading, where the bets are on the first moment of
the marginal distributions, and where operators rely on the criticized "trader lore" for higher moments.
Such technique, which I call generalized pairs trading, has been carried in the past with large measure of
success by "kids with Brooklyn accent". A use of the covariance matrix that is humble enough to limit itself
to conditional expectations (not risks of tail events) is acceptable, provided it is handled by someone with the
critical and rigorous mind that develops from the observation of, and experimentation with, real-time market
events.

Trader Risk Management Lore : Major Rules of Thumb

Rule 1 - Do not venture in markets and products you do not

understand. You will be a sitting duck.
Rule 2 - The large hit you will take next will not resemble the one
you took last. Do not listen to the consensus as to where the risks
are. What will hurt you is what you expect the least.
Rule 3 - Believe half of what you read, none of what you hear.
Never study a theory before doing your own prior observation and
thinking. Read every piece of theoretical research you can - but stay
a trader. An unguarded study of lower quantitative methods will
rob you of your insight.
Rule 4 - Beware of the trader who makes a steady income. Those
tend to blow up. Traders with very frequent losses might hurt you,
but they are not likely to blow you up. Long volatility traders lose
money most days of the week.
Rule 5 - The markets will follow the path to hurt the highest number
of hedgers. The best hedges are those you are the only one to put on.
Rule 6 - Never let a day go by without studying the changes in the
prices of all available trading instruments. You will build an
instinctive inference that is more powerful than conventional
statistics.
Rule 7 - The greatest inferential mistake: this event never happens in
my market. Most of what never happened before in one market has
happened in another. The fact that someone never died before does
not make him immortal.
Rule 8 - Never cross a river because it is on average 4 feet deep.
Rule 9 - Read every book by traders to study where they lost money.
You will learn nothing relevant from their profits (the markets
adjust). You will learn from their losses.

4 of 4 07-10-2020, 15:01