Why Hedge Funds Blow Up

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Hedge funds and derivatives that rely on statistics and historical relationships/patterns should take note of this article in the Financial Times http://www.ft.com/hippocampus/q14ae5a.htm Article indicates that statistically "rare" events occur more frequently than Bell Curve and standard deviations predict - a lot of "Black Box" investment systems should be recalibrated

SCIENCE: New curve makes life predictable By Michael Peel

Albert Einstein's dictum that God "does not play dice" looks like turning from a great man's aside into a universal truth.

Scientists from Britain, France and the US have discovered a mathematical curve that seems to explain seemingly random events, such as aircraft turbulence and forest fires. Their findings challenge the pre-eminence of the bell-shaped curve, the standard device used to forecast probabilities in areas as diverse as natural disasters and children's exam results.

The new curve is broader and more gently sloping, suggesting that the rarest events occur more often than predicted by the bell-shaped curve.

The breakthrough could have far-reaching consequences in areas such as engineering, insurance and ecology which rely on forecasts of probabilities that specific events will occur.

Donald Turcotte, professor of geological sciences at Cornell University, New York, said he discovered the curve after plotting graphs of the severity of floods in the US. His study suggested the worst incidents occurred more often than indicated by official predictions, which were based on the bell-shaped curve.

The idea of a new universal curve crystallised after quirks of fate brought together scientists working on various natural phenomena including avalanches, earthquakes and the abundance of species in eco-systems.

Their findings suggest that industrialists and conservationists alike may have to review some of the key assumptions underpinning their work.

Chaos theory link

The discovery draws on chaos theory, a branch of maths that revolves around identifying patterns in apparently random sequences of events.

Chaos theory has been used, with varying degrees of success, to account for phenomena from the galactic clustering of stars to the rise and fall of civilisations.

The British, French and US scientists sought to reconcile their findings in the laboratory with the often wild-sounding predictions of chaos theory.

Their work shows that a central concept of chaos theory, known as self-similarity, can be used to connect the results of studies in otherwise unrelated fields, such as turbulence and environmental science.

Dr Steve Bramwell of University College, London, whose research on magnetism helped yield the new curve, said the link he had forged between chaos theory and experimental rigour was "something you can't escape".

Einstein, who sought predictability in the real world and argued that quantum mechanics was an inadequate universal theory, would have approved. ******The harsh reality is that after years of egregious excesses, the inevitable downside of our historic credit and stock market bubbles appears at hand. Most unfortunately, the worst credit and speculative excesses have occurred during the past nine months, since the Greenspan rescue this past fall. This ushered in the final, wild and manic "hot money" flows into the dollar, US stocks and fixed-income securities, and the great Internet/Telecom bubble. It led consumers to dip into savings and take on mortgage and credit card debt like never before. It led businesses to borrow excessively and spend in ways that will likely appear ill advised down the road. And it led to speculation the likes of which have not been seen since the peak of the mania in 1929. Now, however, the inevitable crisis has arrived and it is focused directly at where the greatest excesses took place -right here in the US.****************

-- Ponzi (Ponzi@Crash.in99), September 04, 1999


Although I think the bubble will burst sometime in the next few months, I see no evidence that the inevitable crisis has arrived at this point. Things are booming.

-- cody (cody@y2ksurvive.com), September 04, 1999.

Thanks Ponzi - won't be long now...

-- andy (2000EOD@prodigy.net), September 04, 1999.

I knew this when I was a kid. In fact this was reinforced in High School and college statistics. It's called kurtosis and most hedge fund managers knows this about this. In fact I plan my life around this concept of "leptokurtosis." [it's commonly know as Murphy's Law]

-- Serio (survival@y2k.com), September 04, 1999.

>> I see no evidence that the inevitable crisis has arrived at this point. Things are booming. <<

I have a hunch the first decisive shot will be fired in the currency market. Most of the crises of the past 15 years have been signalled first in the currency exchanges. They trade $1 trillion every day in that market, and the money moves like lightning!

So, I am watching the dollar to yen relationship. It is weak, but not quite in a free fall. I could be wrong. I can't track every whisper of obscure breaking news, like the pros do. When they hear the "key piece" of bad news, their actions will speak loudly and the effect of that news (whatever it turns out to be) will be amplified enough to reach my ears.

That's when I'll know the party is over.

-- Brian McLaughlin (brianm@ims.com), September 05, 1999.

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