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What is Business Risk?

Nassim Taleb has a nice rant about the traditional model of risk: the future will turn out to be much like the past, and risk is a measure which calculates how that path will vary.

Taleb objects, I think correctly, to a view of business risk which is built upon the 17th century gaming model.

Probability theory is about 300 years old and evolved out of a practical discussion about how to evaluate or calculate the relative pay-offs of card or gambling games which had not finished.

Taleb thinks these model types radically underestimate important risks.

Taleb's argument is with professional economists like Dan Rodrik who claim:

"A comforting thought ? if you still want to believe in financial sanity _ is that this was a case of a ``perfect storm," a rare failure that required a large number of stars to be in alignment simultaneously."

Paul Wilmot, at the New York Times, has a similar jaundiced view of the professional modelers of financial risk:

"I spend a great deal of time speaking to people in banks about their mathematical models.

I know which are using good models (a very few banks) and which are using bad models (most banks).

I know of the dangers present, from a quantitative-finance and risk-management perspective. And for many years I have explained these dangers to anyone who would listen, and I will continue to do so.

So it is incredible to think that ratings agencies, which must also have detailed knowledge of the nature and, more important, size of the toxic transactions, will happily give out their multiple A grades without any feeling of shame.

And then the word "theoretically" becomes very important. I have attended many conferences on quantitative finance, at which professors and practitioners describe their latest models for derivative instruments and the like.

All the time I'm sitting in the audience thinking that these models are far too simplistic and based on countless unrealistic assumptions.

I tell people that these instruments are dangerous, that no one understands the risks. But no one cares."

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Full post as published by Misleading Advertising Law on October 13, 2008 (boomark / email).