Friday, 17 August 2007

There is no risk

Well not quite. But here's the thing. Roubini Economics Monitor discusses the distinction between risk (in his terms variability in outcomes that can be estimated statistically) and uncertainty (unknown or unmeasurable outcomes). The basic idea in this article is that risk can be priced but uncertainty can't:
Economists distinguish between “Risk” and “Uncertainty”: the former can be priced by financial markets while the latter cannot. The distinction between the two was made by the famous economist Frank H. Knight in his seminal book, Risk, Uncertainty, and Profit (1921). In brief, “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”.
This is all very well but unhelpful as in these terms the financial markets have no risk, just uncertainty. We never know that our modelling is right and we have correctly estimated risk because we don't know what random process the underlying is following. We don't known what lies beneath. We just hope for the best and under ordinary conditions mostly we are right.

Structuring does not add to uncertainty, it just translate an unknown return distribution into an unknown P/L distribution in a deterministic way. Thus while this quote correctly describes some of the RMBS market:
First, you take a bunch of shaky and risky subprime mortgages and repackage them into pass throughs; then you repackage these PTs in different (equity, mezzanine, senior) tranches of cash CDOs that receive a misleading investment grade rating by the rating agencies; then you create synthetic CDOs out of the same underlying RMBS; then you create CDOs of CDOs (CDO squareds) out of these CDOs ... then you stuff some of these tranches into SIVs or into ABCP conduits or [even] into money market funds.
It does not effect the epistemology of the situation. What we are seeing now is a combination of leverage (which again purely deterministically magnifies any modelling errors) and model risk producing a liquidity crisis as people have suddenly noticed how uncertain the value of their securities is. That doesn't mean it wasn't uncertain earlier, just that they didn't know it was uncertain. Those unknown unknowns have become known unknowns, and that is why we have a problem.

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