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Up the Devils Staircase, Down the

Fi i l Ab Financial Abyss
Paul Embrechts Paul Embrechts
Department of Mathematics Department of Mathematics
Director of RiskLab, ETH Zurich
Senior SFI Chair
www math ethz ch/~embrechts www.math.ethz.ch/ embrechts
Ceterum censeo Carthaginem
esse delendam * esse delendam
(N.H. Bingham, 20/5/2011)
M. Porcius Cato Cato The Elder
Rome, 234 - 149 B.C.
* Furthermore, I think that Carthage must be destroyed!"
The title in pictorial form The title in pictorial form
(M.C. Eschers Stairs)
TheDevilsstaircase:inMathematics
A monotonicincreasing"staircase"forwhichthe
simplestrationalnumbershavethelargeststeps.The
Devil'sstaircasecontinuouslymapstheinterval[0,1]
onto[0,1],butisconstantalmosteverywhere (i.e.,
exceptonaCantorset).
TheDevilsstaircase:onWallStreet
Abacus2700AC1
ABSCorr.Trade
(1) FractionalReserveBanking
(2) BSM papers in 1973 creating The Market
CashCDO
SyntheticCDO
CDO**2/3
(3)
HybrydCDO
(2) BSMpapersin1973,creatingTheMarket
throughdynamicreplicationandimplied
volatility
Futures
Options (Credit)Derivatives
ABS/CDS
(2)
Stocks
Bonds Mortgages
Futures
Money
Commodities
(3) 2006 h i f f h l
FRB(1)
Goods
(3) 2006sawthecreationofoneofthemostunnatural
anddestructivefinancialproductsthattheworldhas
everseen,thesyntheticCDO,itturnedthekegofdyna
mite into the financial equivalent of a nuclear bomb miteintothefinancialequivalentofanuclearbomb.
(Allthedevilsarethere,B.McLean&J.Nocera,
Portfolio/Penguin,NewYork,2010,Chapter17)
ForamusicalrecreationofWallStreetsfolly,
you may want to listen to youmaywanttolistento
GyrgyLigeti,tudeNo.13,
L li d di bl Lescalierdudiable
(TheDevil'sStaircase)
A sobering thought Asoberingthought
D.J.Hand:OnWallStreet,gainmaximisation often
leadstoconstrainedoptimisationproblemsmoving
evercloserto(*) theethicalboundary
An example: John Paulsons shorting of AAA Anexample:JohnPaulson sshortingofAAA
tranchesofaspeciallyconstructedsyntheticCDO,
(1) It didnt pass Bear Stearns ethic standards (1)Itdidn tpassBearStearn sethicstandards,
(2)GoldmanSachs allowedJPtorent(15Mio$fee)
the Abacus brand name and go ahead with the deal theAbacusbrandnameandgoaheadwiththedeal
throughGSsemployeeFabriceTourre.
(*)beyond?
LeadingtosomeofWallStreetsmost
sickening acts on so called Frankenstein derivatives sickeningactsonsocalledFrankensteinderivatives
Well,whatifwecreatedathing,whichhas
nopurpose,whichisabsolutelyconceptual p p y p
andhighlytheoreticalandwhichnobody
knows how to price? (FT 29/1/07) knowshowtoprice? (FT,29/1/07)
IvemanagedtosellafewAbacus bondsto
h h h widowsandorphansthatIranintoatthe
airport,apparentlytheseBelgiansadore
syntheticABSCDO2(FT,13/6/07)
The Fabulous Fab TheFabulousFab
b d h f h l Remember,westandatthetopoftheDevils
Staircase,early2007:
FTsJanuary23,2007,ominousemail:More
and more leverage in the system The whole andmoreleverageinthesystem.Thewhole
buildingisabouttocollapseanytimenow...
O l t ti l i th f b l F b[ i Onlypotentialsurvivor,thefabulousFab[rice
Tourre],standinginthemiddleofallthese
complex,highlyleveraged,exotictradeshe
createdwithoutnecessarilyunderstandingallof y g
theimplicationsofthosemonstruocities!!!
S th ti l l hi Somemathematicalsoulsearching,
from L.C.G. Rogers (Cambridge, UK), fromL.C.G.Rogers(Cambridge,UK),
SPAPlenaryLectureon
MathematicalFinance,theP&L
Osaka Japan Osaka,Japan
September6,2010
Begin of quote:
On some fundamental results from
mathematical finance (MF): they take us
somewhere we dont want to go starting somewhere we don t want to go, starting
from a place we didnt need to start
A littl f h t MF h d h b A little of what MF has done has been
VERY useful ... Most of MF has addressed
completely irrelevant issues, and
misapplied the energies and talents of a misapplied the energies and talents of a
young generation in the process!
OnMathematics,FinanceandBanking,
Rogerscontinued:
Inmaths,aresultisrightiffits , g
proved
Inmathfinance,aresultisrightiff
its published it spublished
In banking, a result is right iff its In banking,aresultisrightiffit s
profitable
Endofquote.
Myownview,inlinewithstatements
madebyHansFllmer andothers
Butfirst
Mathematics is of key importance for Mathematics is of key importance for
understanding and clarifying models and prices understanding and clarifying models and prices
used in finance, insurance and economics
making heuristic methods mathematically precise, making heuristic methods mathematically precise,
and asking for clear, unambiguous definitions!
highlighting model conditions and restrictions on highlighting model conditions and restrictions on
applicability
working out numerous explicit examples working out numerous explicit examples
leading the way for stress testing and robustness
properties properties
and it would be bad if the current crisis would
induce a shying away from mathematics! induce a shying away from mathematics!
I do hope that: I do hope that:
Other academic fields like micro-, macro-
economics, econometrics, banking, , , g,
corporate finance, law, accounting ... do a
similar soul searching similar soul searching
And then I have not yet started with the
other actors: industry, politicians,
regulators, investors, the press ... g p
this is really crucial as
f i i bl ! we are facing a very serious problem!
Interludium:
From trillions of $ to picoseconds:
1 tri $ = 1 000 000 000 000 $
$ p
$ 000 000 000 000 $
World GDP = 58 tri $, US GDP = 14.5 tri $
(US deficit 1 35 tri $ debt 13 6 tri $) (US deficit = 1.35 tri $, debt = 13.6 tri $)
Nominal amount CDS (6/10) = 30 tri $, but ( )
62 tri $ at its 06-07 peak
Nominal amount of OTC (6/10) = 583 tri $ Nominal amount of OTC (6/10) = 583 tri $
CDO volume 2006: 2.7 tri $
Moving from 1 trillion $ to 1 trillionth of a
second (a picosecond): high-frequency second (a picosecond): high-frequency
trading co-location! Consequences?
An early warning of things to come?
The Flash-Crash of May 6, 2010!
- 998.50/9.2%
- 600 in 5
Hence new Risk Management challenges!
From Not so fast, Buttonwood,
The Economist, August 6-12, p. 55
NASDAC 1 trade/250 micro sec
HFT ~ 2/3-3/4 total Wall St volume HFT 2/3 3/4 total Wall St volume
Smaller spreads, liquidity sales pitch
HFT and best capital allocation?
Average holding time of stocks 4 months Average holding time of stocks 4 months
Boundary play (PE), spoof orders
Positive correlation (volume, volatility)
Potential dislocation between share prices Potential dislocation between share prices
and economic fundamentals ...
On the role of Mathematics:
The two dimensions of (Q)RM
((Quantitative) Risk Management)
Dimension 1: Scope
Mi th fi t di fl th li t Micro: the firm, trading floor, the client
Macro: the worldwide system y
Di i 2 Ti Dimension 2: Time
Short (HFT): << 1 year (or quarter) S o ( ) yea (o qua e )
Medium (Solvency 2/Basel III): ~ 1 year
Long (Social/Life Insurance): >> 1 year
Two examples (micro short): Two examples (micro-short):
Modelling of Extremes
Beware of (micro ) Correlation Beware of (micro-) Correlation
ModellingofExtremes g
RMtoooftenfrequency oriented...
everysooften(rareevent)
t i d 1 i t returnperiod,1inxyearevent
ValueatRisk(VaR) ( )
...ratherthanmorerelevantseverity orientation
h if whatif
losssizegiventheoccurenceofarareevent g
ExpectedShortfallE[XIX>VaR]
ThisisnotjustabouttheorybutaRMattitude!
ThePeaksOverThreshold(POT)Method ( )
Crucialpoint!
99%quantile with 95% aCI (Profile Likelihood): 99% quantilewith95%aCI(ProfileLikelihood):
27.3 (23.3,33.1)
99% C diti l E E( X I X 27 3) ith 95% CI 99%ConditionalExcess:E(XIX>27.3)witha95%CI
58.2
99%quantile
99%conditionalexcess
27.3
Several extensions of 1 d EVT exist: Severalextensionsof1dEVTexist:
i i Nonstationarity
CovariablemodellingwithinPOT g
Bewareofdiscrete data,nonstandardtheory
Multivariate extremes: definitions Multivariate extremes:definitions
Several,questiondependent approachesexist
Dynamic,stochasticprocessmodels
Diagnostic and graphical tools Diagnosticandgraphicaltools
Important:Communicatingextremeevents
f l !!! Warning:oftenveryslowconvergence!!!
Bewareof(micro)Correlation
micro-
The normal distribution The normal distribution
E t tt Extremes matter
Correlation matters
As a consequence: As a consequence:
Th i i ( d h d i ) f i The pricing (and hedging) of super-senior
AAA CDO tranches has substantial model
uncertainty (= MU), What are your marks?
Beware of correlation tradingg
Pricing of CDO**2/**3, synthetic CDOs,
besides being more than questionable from besides being more than questionable from
an economic point of view, is quantitatively
near impossible (MU) near impossible (MU)
Hence beware of warehousing such risks!
Similar examples with other products
With respect to the crisis,
in particular:
Personalities: too many Gordon Geckos out
there, at all levels
The near total failure of risk management (of the
type get out of the way) yp g y )
The belief in the existence of a lender of last
resort government guarantees resort, government guarantees
Collateral calls/triggers (embedded)
N l l d f LTCM 1998 No lessons learned from LTCM 1998
Near criminal accounting (e.g. REPO 105) and
regulatory arbitrage (between BB and TB)
Some very basic RM rules: y
If you dont understand it, dont buy/sell it
Speak to the guys in the boiler room Speak to the guys in the boiler room
Beware of new paradigms, like the New
Economy, the New Risk Management:
new usually means that tried and trusted
measures of the past are being ignored
Always understand your gains and beware Always understand your gains and beware
of volume (even/especially AAA)
Concerning Basel II+ or III: do not try to Concerning Basel II+ or III: do not try to
reinvent the wheel, check countries and
institutions that came through the crisis institutions that came through the crisis
less harmed, understand why!!!
Thankyou! y