risk in the real world1.pptx

risk in the real world1.pptx - Risk Management in the Real...

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Risk Management in the Real World Introductory Lecture 1
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Introduction Option-Theoretic Approach to Model Errors Develop intuitions of Errors from models Convexity to errors/Missing sources of stochasticity Role of extreme events 2
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Risk Management • The inseparability problem • Bias: commission v/s ommission • Redundancy as an option N N Taleb © 2008 3
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Freedman’s Gift N N Taleb © 2008 4
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General Themes: Defects, Errors, & Risk Management 1- Tricks and Methodologies: “street- smart thinking” 2- Understanding Volatility, Convexity, Fat Tails, and Opacity 3- Structures, Randomness (observational biases), and Feedbacks 4- Mental Biases /Psychology of Risk 5- Complexity Theory and Macro-view of Fragility, Robustness, and Redundancy 5
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TA Literature: – PowerPoint of lecture – TBS – Research papers – YOUR lecture notes – Blackboard discussions Quiz Next Lectures Feb 18/March 4/March 11 N N Taleb © 2008 6
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Lecture 1, part 1 Tricks & Small Errors N N Taleb © 2008 7
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A Common Error • A currency has 5% interest rates (can be generalized to any security). The base currency (costs of funds) is 5%. • The underlying moves up 1% a day for 22 days in a row. • How do you compute volatility (Standard Deviation) for the PURPOSE of decision-making (option pricing)? N N Taleb © 2008 8
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STD = Sqrt[(E[X-E[x]) 2 ] MAD =E[|X-E[x]|] When you are facing an uncertain outcome you do not expect the mean return to be 1% a day. You simply expect 0% drift. Therefore you should not center volatility around the ex post drift but the ex ante one In other words, the options would produce the P/L of 0 volatility if and only if the drift is expected to be 1% The classical anticipating-nonanticipating strategy. AN OPTION BREAKS EVEN AT 16% VOL (+- some adjustment) NOT 0. N N Taleb © 2008 9
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Corollary A currency has 100% annual interest rates [paid daily]. Base currency is 5%. The exchange rate does not move for a month. What is volatility (monthly, annualized)? N N Taleb © 2008 10
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Not Drifting The idea of follows: something that is supposed to drift BUT DOES NOT DRIFT is volatile. N N Taleb © 2008 11
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Consequence When a currency has a high interest rate, spot volatility is totally irrelevant. Using HVT on Bloomberg is not an intelligent idea. (The problem with the question: 100% interest rates can be ambiguous when translating into daily rates. I meant the daily equivalent of 100% interest rates. ) So where r is the daily rate, the answer is : STD= [Sqrt[ Sum [i=1, i=22] [ (0 - r)^2]/22] Sqrt[256] (annualized) MAD= Sum[i=1,i=22][Abs[0-r]/22] N N Taleb © 2008 12
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N N Taleb © 2008 Volatility defnition Ask someone to provide you with an “English” defnition oF volatility 13
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N N Taleb © 2008 What does volatility mean (1)?
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risk in the real world1.pptx - Risk Management in the Real...

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