Risk Management Society Publications

January 2011

Modeling the (Mis)Behavior of Markets:

Lessons for the Future
RMS Research Team | Yee Jun Xian, Eugene Tham
Modern finance is largely built on the Efficient Market Hypothesis
(EMH). Business students will (probably) fondly recall this theory,
which asserts that one cannot consistently achieve returns in excess of
average market returns on a risk adjusted basis, given the information
publicly available at the time the investment is made. In particular, it
assumes that stock prices follow a random walk model, and it is
impossible to beat the market. Current prices are approximately equal
to the intrinsic value. If prices are too high, rational traders will
quickly take advantage of the opportunity to sell the stock and make a
profit. Similarly, if prices are too low, rational traders will quickly buy
the stock, pushing the price to the equilibrium level. The logic
Eugene Fama, pioneer of the
behind EMH is clear and simple.
Ecient Market Hypothesis
For the past few decades, the EMH was widely considered to be the
Holy Grail of Finance. EMH assumes that price changes are random and they meander around a
polite Gaussian average. This concept was a breakthrough in risk management. It held the
promise that the stock market, so often wild and unpredictable, could finally be tamed. The
Gaussian bell curve became ubiquitous in financial models, as delighted financiers assiduously
apply the Gaussian bell curve to elaborate financial models, confident in their belief that risk has
finally been conquered. With the EMH as the
Monthly Percentage Price Changes in S&P
cornerstone, numerous theories sprang up.
Prominent ones include the Black-Scholes
Model of option pricing, Value-at-Risk
Model, and Capital Asset Pricing Model. All
these theories are milestones in risk
management history, and revolutionized the
entire business arena. Companies use them
to make important decisions, banks use
them in their daily operations, and
regulators rely on them to safeguard the
financial system. They have become
omnipresent, indispensible for success.
Notice how the nasty bulges at the tails does not
exactly conform to a Gaussian distribution
(Source: Against the Gods: The Remarkable Story of
Risk)

elegant. Unfortunately, it is also wrong.

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The Gaussian bell-curve, the assumption

upon which EMH is founded, is easy-to-use.
Probability, expected return, variance and
risk all become quantifiable, where the
formulas reduce everything to a single, easyto-comprehend number. It is neat. It is

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To a large extent, financial innovations using the Gaussian bell curve are certainly useful. But
they work only as a guideline. As we shall see in this article, to treat these theories as the Holy
Grail of finance, applying them to reality with no consideration of their essence, will inevitably
lead to widespread self-destruction. Models only serve as a guideline for reality. To try and force
reality to conform to models is a recipe for disaster.

Black Monday (1987)

The Black Monday was the first significant occurrence in history where the market simply failed
to function according to EMH.
Then, Portfolio insurance, which is a method of hedging a portfolio of stocks against the
market risk by short selling index futures was the favorite risk management technique in Wall
Street in the 1980s as computers become powerful enough to utilize the strategy efficiently.
Invented by Hayne Leland and Mark Rubinstein in 1976, investors can protect themselves
against wild price swings downwards by sacrificing some gains. The portfolios are thus
insured, protected from any adverse events. With a small price, risk is eliminated completely.
Or so the investors thought.
The shortcomings of portfolio insurance were finally brought to light abruptly in 1987. On 19
October 1987, the DJIA dropped by 508 points to 1738.74(22.61%), the largest one-day
percentage decline in stock market history.
On the weekend before the crash, a huge backlog of sell orders had built up. Managers of
insured portfolios sold index futures, and with the futures market in Chicago even lower than
the stock market, traders attempt to arbitrage by selling stock once the market opened.
The result was that stock prices plunge even further, and this created a vicious feedback loop
where managers were forced to sell even more futures to insure their portfolios. Suddenly,
portfolio insurance, so long regarded as an eminent risk management technique, was revealed to
be full of gaping holes. Liquidity suddenly dried up, and no buyers can be found for the prices
the managers demanded, a scenario impossible according to EMH and the rational expectations
theory. Conventional finance theories had failed, and investors were left to pick up the pieces
after the nightmare.

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(Source: The Internet and Inves3ng)

Dow Jones returns before and a@er the 1987 Stock Crash.

The Long Term Capital Management Debacle (1998)

Almost a decade later, the weakness of EMH is once again exposed in the Long Term Capital
Management (LTCM) debacle, where its impressive gains were only exceeded by its even more
impressive losses.
LTCM was a hedge fund management firm founded in 1994 by John Meriwether, then a
renowned bond trader. It opened to much fanfare, for it was viewed as the ultimate statistical
trading firm. At one point in time, it had as many as 25 PhDs on its payroll, including two Nobel
laureates, Myron Scholes and Robert C. Merton, both of whom worked on Black-Scholes option
pricing theory. LTCMs models utilize highly advanced mathematics and quantitative techniques
to reduce risk. It was a turning point in the world of finance, where the new quants will pit
their skills against the traditional traders.
For some time, it did seem that the mathematics work. LTCM used complicated models to take
advantage of mis-pricings in bonds, known as fixed income arbitrage or convergence trades.
These differences in values are minimal, and in order to make a significant profit, the firm
needed to take on highly leveraged positions. Debt-to-equity ratio soared to over 100 to 1. Not to
worry. Economic theory states that any difference in prices would be eliminated through
arbitrage. The models showed that the risk was minimal. The science of EMH, diversification

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theory and the rational market worked its magic. In its first four years, LTCM returned an
average of over 40% annualized gains, all with stunningly low volatility. Not once did it suffer a
monthly loss of more than 1 percent in 1996. We cant get the risk high enough, the traders
remarked. Were seeing the power of diversification. Investors were overawed.
Then, in 1998, crisis struck. The Russian government defaulted on their government bonds.
LTCM lost $4.6 billion in less than four months. Trades that were supposed to converge did not.
Assets which were supposed to be uncorrelated suddenly became correlated. Thus began a flight
to liquidity by other investors and LTCM lost all its previous gains, and then more. The
conclusion was inevitable. By then, LTCM had a leverage ratio of over 250-to-1, and the Federal
Reserve Bank of New York had to organize a massive bailout to avoid a wider collapse in the
financial markets. From then on, LTCMs strategies became referred to as picking up nickels in
front of a bulldozer.

Comparison of LTCM, Dow index and US bond return

Source: www.thefullwiki.org/ltcm

How can it be that the brilliant mathematicians failed so dramatically? The econometrician at
LTCM claimed that it was a ten-sigma event that caused the collapse of LTCM. If this was true, it
meant that LTCM was spectacularly, unimaginably and unbelievably unlucky, for its collapse
was a 1 in a 1024 chance. LTCM failed because of this 1/1,000,000,000,000,000,000,000,000
chance.
More likely, however, it is simply that the models LTCM were using are wrong. The science
behind the models is not science after allit is simply pseudo-science. The EMH led LTCM to
greatly underestimate the risk that they were facing. Yet, exponents of EMH viewed the rise and

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fall of LTCM as a beautiful victory for conventional economics. But one cannot help but notice a
supreme irony. The fund was marketed to investors as using EMH to obtain supernormal
returns, even while EMH itself claims that one cannot make supernormal profits consistently.
If LTCM simply failed to make money, the reputation of EMH would be unsullied. Investors are
unable to beat the market, after all. Hence, the case of LTCM disproves EMH in two ways.
Firstly, they proved it possible to make large profits, profits that should have been impossible
according to EMH. Secondly, they lost all their money when the market conditions
changed drastically, an occurrence which also should not have been possible according to the
EMH.
EMH was disproven. And yet, the world proceeded on triumphantly as if EMH had emerged
victorious.

Financial Crisis (2008)

As stability gradually resumed, and investors regained confidence in the EMH, the Financial
Crisis of 2008 was on hand to deal the fatal blow to this fragile hypothesis. While myriad factors
contributed to the crisis, the foremost reasons that critics cite are (of course) the incorrect
assumptions of the EMH and the inaccurate pricing of risk by financial models.
A key factor that led to the collapse of the banking industry was the increasing use of
mathematical models, spurred by the desire to exert total control over risk. These models, in all
its elegance and beauty, badly underestimated the occurrence of extreme events. Of particular
note is a modeling technique called the Gaussian copula, which puts a price on the risk of
multiple assets (or in this case, mortgages) defaulting at the same time. Upon its introduction by
a quant named David Li, the popularity of this model sky-rocketed and the banking industry
embraced it gleefully as the final piece to the risk management jigsaw that the industry had been
piecing together. Ratings agencies such as Moodys and the S&P readily adopted it in
formulating company credit ratings, and the model finally found its way into the Basel II
regulatory framework, as the guideline to calculate capital requirements for banks based on
structured credit that they hold.
How, then, could the Gaussian copula, so widely regarded as the be-all and end-all of risk
management, have been the cause of the banking industrys collapse? In short, it failed
spectacularly. Its failure stems not from the model itself. Theres
nothing inherently wrong with it. Rather, the problems erupted from a
lack of understanding and the resulting misuse of this model,
throughout the industry. The model was so complex that not many
quants, much less the fund managers, understood how the model
works. It became a black box whereby assumptions were simply
inputted and results were obtained and used unquestioningly in
making financial decisions. Few doubted if the assumptions made were
correct. Even when some did, the questions were brushed off. The big
banks took the assumptions as they were, and failed to constantly
adjust to reflect the true market conditions. David Li himself warned,
Nassim Taleb
years before the financial crisis, that Very few people understand the

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essence of the model. Nassim Nicholas Taleb, author of The Black Swan, was also a vocal critic,
claiming that The thing never worked. Yet, nobody heard them.

The Development of Rival Theories

With all these failures, why do we continue to use EMH? One reason is perhaps because, as
mentioned previously, EMH is easy-to-use and easy-to-comprehend. The Gaussian distribution
can reduce unknown variables to a single number, and investors can bask in that warm tingly
feeling that comes with the (false) sense of security. Positions are hedged, losses are curtailed,
and liabilities are controlled (according to paper calculations). Unfortunately, too often, reality
does not respect the paper calculations. As Taleb aptly puts it You still hear people in banks
who use VAR telling you that it works most of the time, as if one should ride a plane that
doesnt crash most of the time.
Yet, there are certainly alternatives to the EMH, the Gaussian distribution and its
contemporaries. The biased random walk model, Extreme Value Theory and multi-fractal
geometry are some such developments that could rival conventional theories. We now touch on
three important fields that could offer promising alternatives to the EMH.

Behavioral Finance
One idea which had gained much traction in recent years would be that of behavioral economics.
Daniel Kahneman, Amos Tversky and Richard Thaler are the pioneers in this field, which
applies psychology to the field of economics. After several decades proclaiming that human
beings are rational, economists have finally discovered that humans are maybe not so rational
after all. Behavioral economics seek to incorporate this aspect of human beings which had been
overlooked for so long.
Human beings can be irrationally exuberant. Plagued by delusions of grandeur, they can become
a rampaging horde that drives prices up to unsustainable levels. Or human beings can be
irrationally fearful, suddenly inflicted with visions of penury that cause them to react like a
frightened mob, selling at whatever price they can get. History is replete with such examples,
from the Tulip mania in 1637 up to the tech boom in the 2000s. Behavioral economics aims to
understand these irrational impulses and seeks to control or overcome them.
To give an example, one result that has emerged out of behavioral economics is that human
beings are generally risk seeking when avoiding loss and risk averse when seeking gains. Daniel
Kahneman and Amos Tversky conducted a study where people are asked if they would rather
have $500 with certainty or flip a coin and receive $1000 if it comes up heads and nothing if it
comes up tails. Most people opt to have the $500 straight. However, when asked if they would
rather pay $500 with certainly or flip a coin and pay $1000 if it comes up heads and nothing if it
comes up tails, most people prefer to flip the coin. Statistically, both experiments are the same
and there should not be any differences in the outcome if human beings are truly rational. The
differences that emerge are thus due to human bias in decision-making. People feel the pain of
loss far more than the happiness derived from gain.

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Behavioral finance has helped plugged many holes left by EMH in explaining financial market
phenomena. For example, Thaler identified complexity and herd behavior as central reasons
behind the 2008 Financial Crisis. Market participants have also been shown to exhibit irrational
herd behavior such as flight to quality, as well as employing hyperbolic discounting (i.e.
discounting the value of a later reward by a factor of the length of the delay). Behavioral finance
appears a promising approach, and may lead to significant findings and practical applications in
the near future.

Power Laws
Another alternative would be using power laws and
fractals instead of the Gaussian distribution. The idea of
power laws and fractals in the financial markets is first
pioneered by Benoit Mandelbrot, and subsequently
popularized by Nassim Nicholas Taleb. This theory states
that the markets are not just randomthey are turbulent.
Randomness associated with Gaussian distributions is too
polite, too courteous, and is too unrealistic. Turbulent
markets, on the other hand, incorporate a wild kind of
randomness into consideration, which is characterized by
sudden large jumps in volatility. Power laws take into
account fat tails, where there is a higher chance that a
single observation or a particular number can affect the
total in a disproportionate way.

Mandelbrot set, an example of a fractal

Benoit Mandelbrot and Nicholas Nassim Nicholas, in an article from the Financial Times,
explain power laws using the example of book sales:
Line up a collection of 1,000 authors. Then, add the most read person alive, JK Rowling, the
author of the Harry Potter series. With sales of several hundred million books, she would
dwarf the remaining 1,000 authors who would collectively have only a few hundred thousand
readers
Unlike height and weight, book sales do not follow a Gaussian bell-curve. Similarly, with
financial markets, the environment is characterized more by random jumps than by random
walks. And thus, this is how LTCM can manage to lose all of its gains and then more in just four
months. This is how a 10-sigma event, supposedly impossible, can occur so readily.
Power laws and fractals place much more emphasis on uncertainty and rare, large-impact
events. Compare this with the Gaussian distribution, which has no explanation for these outliers
and naively dismiss them as statistical anomalies. Power laws may be more accurate, but they
are undoubtedly more difficult to work with for they do not yield precise recipes. Much work
remains on this area.

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Returns of US Stock Market With and Without the Ten Biggest One-day Moves

By removing the ten biggest one-day moves from the U.S. stock markets over the past
@y years, we see a huge dierence in returns and yet convenWonal nance see these
one-day jumps as mere anomalies. (This is only one of the many such tests. While it is
quite convincing on a casual read, there are many more-convincing ones from a
mathemaWcal standpoint, such as the incidence of 10 sigma events.)
(Source: The Black Swan)

Chaos Theory
A similar idea to fractal theory is Chaos theory. Ever heard of the butterfly effect? A butterfly
flaps its wings... a hurricane strikes miles away. Now apply it to the financial markets.
Fanciful, you say. Ridiculous. Maybe. Imagine a truck driver got sacked by his company. He
drowns his sorrows at the local pub, but his sense of injustice is still not appeased. He goes to
steal the company truck and runs down a man crossing the road. That man happens to be the
owner of the largest investment firm in the world. The financial markets are thrown into
disarray. All because of the seemingly innocuous, unrelated event of a driver who got fired.
The butterfly effect was coined by Edward Lorenz, a mathematician and meteorologist, who,
when attempting to predict the weather, discovered that minute differences in the values of the
initial variables led to drastically different weather outcomes. This yielded the result that the
long-term weather cannot be predicted accurately. In fact, current technology only allows
weather to be predictable one week ahead.
How is this result applicable to the financial markets? Financial markets bear the hallmarks of a
chaotic system. They can be viewed as (non-linear) dynamic systems characterized by
turbulence and unpredictability. Small changes in initial conditions can lead to divergent
outcomes. Using these recurrent themes, researchers have set about applying Chaos theory to
explain how the financial markets work. While Chaos theory has not proven as effective in

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explaining phenomena in the financial markets as in other fields as thermodynamics, it is one of

the approaches to watch in time to come.

Where do we go from here?

With the abject failure of EMH and the Gaussian copula, alternative
approaches are given increasing importance as we seek the answer to
understand and control the financial markets. Turning to complex models
proposed by behavioral finance and chaos theory will lead to the creation
of black box models that few people understand. On the other hand, the
complexity of such models may lead us to oversimplify the models and
their underlying assumptions, as our predecessors have done with the
Gaussian copula and the EMH. The great scientist Einstein once said,
Make everything as simple as possible, but not simpler. It is imperative
that we maintain a healthy balance between simplifying the model
sufficiently to be understandable, and harnessing the model to
represent realistic conditions reliably.

Albert Einstein

Further, the system needs a major revamp of the way risk should be managed as it continues to
pick itself up. Should we still persist with the failed theories and models, or do we embrace a
whole new set of tools provided by up and coming theories such as behavioral finance and the
like? Does the problem lie with the models, or us, the users? It is not for us to refute the models.
We will let the evidence do the talking. But if you are to take anything away from this article, you
will do well to make sure you learn this very important lesson: ASK.
Always ask the two important questions: How and Why. How does the model work? Why does it
work? Why does it NOT work? Seek to learn about the model just as you would seek to
understand your partner as fully as possible. Know its strengths and weaknesses, its good and
bad points. Understand when it is useful, and when it is not. As the saying goes, All models are
wrong, but some are useful. If you can constantly bear this in mind, at the very least, you will
not go down the same path as our predecessors.
Isaac Newton lost much of his fortune in the South Sea Bubble, causing him to remark I can
calculate the motions of heavenly bodies, but not the madness of people. The last question
would then be to ask yourself: Are you cleverer than Isaac Newton?

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References
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Bernstein, P.L., 1998. Against the Gods: The remarkable story of risk. New York: John
Wiley & Sons, Inc.

2.

Jones, S., 2009. The formula that felled Wall Street.

http://www.ft.com/cms/s/
2/912d85e8-2d75-11de-9eba-00144feabdc0.html#axzz19epdldfQ

3.

Lee, S., 2009. Formula from hell: The Gaussian copula and the market meltdown. http://
www.forbes.com/2009/05/07/gaussian-copula-david-x-li-opinions-columnists-riskdebt.html

4.

Lowenstein, R., When genius failed: The rise and fall of Long Term Capital Management.
New York: Random House, Inc.

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Mandelbrot, B., & Taleb, N. N., 2006. A focus on the exceptions that prove the rule. http://
www.ft.com/cms/s/2/5372968a-ba82-11da-980d-0000779e2340,dwp_uuid=77a9a0e8b442-11da-bd61-0000779e2340.html#axzz19ek3l9Ri

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Panzner, M. J., 2007. Portfolio insurance the same old short comings. http://
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Salmon, F., 2009. Recipe for disaster: The formula that killed Wall Street. http://
www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all

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Schay, A., 1997. Flawed insurance. http://www.fool.com/Features/1997/

sp971017CrashAnniversaryFlawedInsurance.htm

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Schrager, A., 2009. Further thoughts on copulas. http://www.economist.com/blogs/

freeexchange/2009/04/further_thoughts_on_copulas_1

10. Taleb, N. N., 2005. The black swan: The impact of the highly improbable. New York:
Random House, Inc.
11. Triana, P., 2010. The flawed maths of financial models. http://www.linkedin.com/news?
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12. Wales, D, 2009. Valuation and risk measurement models under heavy criticism what
went wrong? http://www.thepersonalfinancier.com/2009/01/valuation-and-riskmeasurement-models.html

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Other Sources
13. Google Images. http://www.google.com.sg/imghp?hl=en&tab=wi
14. The Full Wiki, Long-Term Capital Management. http://search.thefullwiki.org/LTCM
15. The Internet and Investing. http://iml.jou.ufl.edu/projects/fall07/Casamassa/internal/
trends.html

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