Extreme events part 2. Financial catastrophes. The overthrow of modern financial theory

In this paper we consider Extreme Financial Events. These events are much more common than conventional theory anticipates, and like geophysical extreme events have a number of key characteristics that are found over and over again in actual examples. They are “unexpected”, and therefore not capable of being managed within the capital base, which the consequence that a single event compounds into a cascade of failures. One distinction is that whereas insured catastrophes destroy real economic value, financial catastrophes in the main only destroy financial value. There is also a reputation loss. Management philosophies such as 6 sigma (which really means plus or minus 3 sigma) do not help in understanding or managing such events. It assumes that everything is in a “normal” Gaussian world – where in practice real 6 sigma deviations really do occur on a regular basis. For example Black Monday would only occur once in every 10 times the current age of the universe. Newer tool kits, such as Levy stable distributions, are needed to analyses such events. The reliance on a standard deviation as a measure of risk is also in appropriate. As actuaries we view events in the past as being a guide to the future. In analyzing extreme financial events we often need to delve far into the past to derive similar financial conditions. At the end of 20 th century the economic conditions changed from one of high interest/high inflation to one of low interest/low inflation. One cause of this could be the opening of markets world wide; in much the same way as reduction in trade barriers caused similar conditions after the Napoleonic Wars. Thus the analysis of such events can help us understand what is happening to day. We are dealing in long term cycles or waves. In the analysis of extreme financial events, there are some differences when compared with geophysical extreme events. As mentioned above, the latter destroy economic value, whereas the former destroy primary financial value. In addition they also destroy reputation. A downturn in the stock market as a result of a geophysical catastrophe is a consequence of the destruction of economic value whereas the downturn in the stock market is a result of a financial catastrophe is consequence of a realignment of the connection between economic and financial value, with economic value often not being destroyed. This paper is subtitled the overthrow of modern financial theory, because it is precisely in the conditions of extreme events that the theories cease to work, and management techniques that are based on such theory tend to fail. One can think of it in the context that Extreme events are equivalent to the extreme of quantum and relativistic mechanics when compared with the Newtonian Modern Finance Theory. The Efficient Market Hypothesis rested on a number of assumptions, made to simplify the equations into solubility, that were in fact demonstrably untrue, particularly in extreme events. We review catastrophe theory and chaos theory as an alternative explanation. The theories of Socionomics and Elliott waves may give some insight into predictability of such events. Given our conclusion that sigma (i.e. the standard deviation) is not a good measure of risk we make the suggestion that entropy of the dynamical system may be a better measure and draw on how this measure fits into known actuarial and risk management techniques. For slides and spreadsheet, go to: http://www.actuaries.org.uk/Display_Page.cgi?url=/giro2002/index.xml