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Hazards of Black Swans *April 3, 2013*

*Posted by larry in economics, Philosophy, Statistics.*

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Black Swan land = massive uncertainty = the domain of ignorance.

Black Swan event (or idea): highly improbable, massive impact, rationalized afterward. A Black Swan is so extreme that its probability distribution is unknown hence there is no ability to assess the risk of encountering it, and hence something of which we are ignorant until it occurs. It is possible to create a financial instrument whose behavior is completely unpredictable and hence whose risk is incalculable. A sufficient number of these in circulation could, under certain circumstances that can not be predicted in advance, trigger a Black Swan event.

Thin-tailed probability distributions give the likelihood of an extreme event too low a probability. Thick-tailed probability distributions provide a greater probability to the likelihood of extreme events. However, even the latter can not adequately handle Black Swan events. Here, we are at the limits of statistics. Thin-tailed: mild volatility at the extremes of the distribution; thick-tailed: harsh to unknown volatility at the extremes of the distribution.

Normal stocks reside in Mediocristan. The derivatives that put us in the red zone are the complex derivatives invented after the early 1970s subsequent to the initial round of deregulation. After the further deregulation of 1999, these types of derivatives went off the scale in terms of risk assessment and potential volatility. (“Mediocristan” must be understood in a Galtonian sense, that of the average. So, in Mediocristan, we are in average-land. Galton’s term, “regression to mediocrity” we interpret as “regression to the mean”.)

The derivative payoff domain lies of course in Extremistan. The payoffs are incredibly complicated and often impossible to assess before they are “traded”. Hence, I have dubbed them Schrödinger derivatives.

Distributions are descriptive and reflect real processes, so any planned alterations must be carried out in terms of the payoff matrix. Therefore, to eliminate as much as possible the hazardous effects of Black Swans, complex financial instruments, such as complex derivatives, could be banned completely or strictly limited in some way.

The only justification of a complex derivative and related synthetic financial instruments is income generation for the few. They do not, and can not, benefit the many, contrary to the claims of some of their advocates, for which there is no evidence. In fact, evidence exists to the contrary – the recent volatility in the price of oil, the run on the pound in the ’90s, the present global financial crisis. All were considered highly unlikely, all had massive impact. And in the last case, where there was, and still is, massive fraud, virtually no one has gone to jail, largely because the event has been rationalized for the benefit of the well-off. Were there many successful prosecutions, many wealthy investors would lose their shirts. Therefore, so far, everything is being done in order to ensure that this does not happen. Even to the disbenefit of society as a whole.

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