Crash of 2008/Tutorials: Difference between revisions
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:''(for definitions of the terms shown in italics on this page see the glossary on the Related Articles subpage [http://en.citizendium.org/wiki/Crash_of_2008/Related_Articles]] | :''(for definitions of the terms shown in italics on this page see the glossary on the Related Articles subpage [http://en.citizendium.org/wiki/Crash_of_2008/Related_Articles]] | ||
=== | ===Data limitations=== | ||
The data used to estimate risk probabilitie were subject to several limitations: | |||
* They were taken from the period of historically low economic volatility that started in the early 1980s and came to be known as the "great moderation" | |||
<ref>[http://faculty.chicagogsb.edu/steven.davis/research/Interpreting_the_Great_Moderation,_NBER_version.pdf Stephen Davis and James Kahn: ''Interpreting the Great Moderation'', National Bureau of Economic Research Working Paper 14048, May 2008]</ref>. | <ref>[http://faculty.chicagogsb.edu/steven.davis/research/Interpreting_the_Great_Moderation,_NBER_version.pdf Stephen Davis and James Kahn: ''Interpreting the Great Moderation'', National Bureau of Economic Research Working Paper 14048, May 2008]</ref>, and as such were applicable only on the assumption that such low volatility would continue. | ||
<ref>[http://www.riskworx.com/insights/theory/theory.pdf] Barry du Toit ''Risk, theory, reflection: Limitations of the stochastic | <ref>[http://www.riskworx.com/insights/theory/theory.pdf] Barry du Toit ''Risk, theory, reflection: Limitations of the stochastic | ||
Revision as of 09:44, 4 December 2008
Risk-management errors
- (for definitions of the terms shown in italics on this page see the glossary on the Related Articles subpage [2]]
Data limitations
The data used to estimate risk probabilitie were subject to several limitations:
- They were taken from the period of historically low economic volatility that started in the early 1980s and came to be known as the "great moderation"
[1], and as such were applicable only on the assumption that such low volatility would continue.
Tail risk
An explanation for risk-management errors that has been put forward by Andrew Haldane (Head of the Bank of England's Systemic Risk Assessment Department) [4] suggests that they arose from investors' and rating agencies' use of linear models based upon the CAPM (Capital Asset Pricing Model) [5]. Such models assume that risks can be represented by the symmetrical bell-shaped normal distribution, and can give inaccurate results if the true distribution has a "fat tail", as a result of which there is a significant additional tail risk. Earlier work by Raghuram Rajan (Director of Research at the International Monetary Fund) suggested that securitised assets may be expected to involve significant tail risks. [6] . Since the events involving such risks are by definition rare, they cannot be expected to be picked up by models based upon a five or six years' run of data.
Credit rating errors
Several reasons have been put forward for the errors made by the credit rating agencies. According to Frank Raiter (former Managing Director and Head of Residential Mortgage-backed Securities Rating at Standard and Poor's) his company had assessed default probabilities using a model based upon the analysis of 900,000 mortgages that had been implemented in 1996, and which did not, therefore, capture the changes in performance brought about by the subsequent increase in the numbers of subprime mortgages [7]. Later - improved and updated - models had been developed, but were not implemented because of budgetary constraints. A 2007 report to the Board of Moody's spoke of a conflict between ratings quality and the defence of market share, and of the danger that ratings of securities might be influenced by pressure from their issuers [8]. The president of another credit rating agency said the their ratings had been made on the assumption that there would be government financial support for any major company that ran into in difficulties [9].
References
- ↑ Stephen Davis and James Kahn: Interpreting the Great Moderation, National Bureau of Economic Research Working Paper 14048, May 2008
- ↑ [1] Barry du Toit Risk, theory, reflection: Limitations of the stochastic model of uncertainty in financial risk analysis Riskworx June 2004
- ↑ Avinash Persaud: How risk sensitivity led to the greatest financial crisis of modern times October 2008
- ↑ Andrew Haldane: "Risk-Pricing and the Sub-Prime Crisis", World Economics July-September 2008
- ↑ See paragraph 2.3 of Financial economics
- ↑ Raghuram Rajan: Has Financial Development Made the World Riskier? , Working Paper No 11728, National Bureau of Economic Research September 2005
- ↑ Frank Raiter: written statement before the Hearing on Credit Rating Agencies and the Financial Crisis by the House of Representatives Committee on Oversight and Government Reform, October 22 2008
- ↑ Confidential Presentation to Moody's Board of Directors, October 2007
- ↑ Statement by the President and CEO of Fitch Inc to the Hearing on Credit Rating Agencies and the Financial Crisis by the House of Representatives Committee on Oversight and Government Reform, October 22 2008