Know your embedded assumptions

An implicit assumption in the way that many practitioners use financial models is that their planned activity is marginal to the market. If you ask the manager of a large mutual find about that assumption and they will generally laugh out loud. They are well aware that their trades must be made carefully to avoid moving the market price. Often they will build up a position over a period of time based upon the normal flow of trading in a security. That is a very micro example of non-marginality. What happened with the sub-prime mortgage market was a drastic shift in activity that was clearly not marginal. When the volume of sub prime mortgages rose 10 fold there were two major changes that occurred. First, the sub prime mortgages were no longer going to a marginally more creditworthy subset of the folks who would technically into the sub prime class, they were going to anyone in that class. Any prior experience factors that were observed of the highly select sub prime folks would not apply to the average sub prime folks. So what was true on the margin is not true in general. The second marginal issue is the change in the real estate market that was driven by the non-marginal amount of new sub prime buyers who came into the market. On the way up, this expansion in the number of folks who could buy houses helped to drive the late stages of the price run up because of that increased demand. That increase in price fed into the confidence of the market participants who were feeding money into the market. Risk managers should always be aware that marginal analysis can produce incorrect results. They should follow my mother’s caution “what if everybody did that?”

Explore posts in the same categories: Assumptions, ERM, Modeling, Risk Management, Sub prime


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2 Comments on “Know your embedded assumptions”

  1. Yes, be aware of embedded assumptions such as “marginality.”

    But it is far more important to be alert to the ways that independent factors may have unobserved correlations.

    The Bhopal tragedy shows why black swans are far more common than supposed. At Bhopal, the several safety mechanisms were indeed independent — electrically, mechanically, chemically…

    BUT there was an occult correlation. Union Carbide and the Indian government wrangled over money, margins, intellectual property, everything. As a result, training and maintenance were ignored.

    Undertrained, understaffed humans ruined the supposedly independent safeties, so correlations converged.

    Thus ever. There are myriad similar examples, especially of the form where a small initial problem is exacerbated by efforts to “fix” or “help.” And so several fairly likely steps build, to create black swans more often than we’d perceive.

    When in a hole, stop digging.

  2. Hey good stuff…keep up the good work! 🙂 I read a lot of blogs on a daily basis and for the most part, people lack substance but, I just wanted to make a quick comment to say I’m glad I found your blog. Thanks,)

    A definite great read.. ..


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