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Is risk modelling

dead?
Maarten
Gelderman

Responses to the
crisis
Is risk modelling dead? Reform by nostalgia
Lessons for us

or Modelling
How to evaluate model

How to kill a black swan shortcomings?


Why the crisis was not a
black swan
The Engle experiment

Wrap-up

Maarten Gelderman

Head of Quantitative Risk Management


De Nederlandsche Bank

June 29, 2009


My key message Is risk modelling
dead?
Maarten
Gelderman

Responses to the
crisis
Reform by nostalgia
Lessons for us

Modelling
How to evaluate model
shortcomings?

Our job is to kill the black swan. Why the crisis was not a
black swan
The Engle experiment

If this crisis is the death of risk Wrap-up

modelling, that’s our fault.


Reform by nostalgia Is risk modelling
dead?
Maarten
Gelderman

Responses to the
I No large banks crisis
Reform by nostalgia
I No financial conglomerates Lessons for us

Modelling
I Retreat to national boundaries How to evaluate model
shortcomings?
I No proprietary trading Why the crisis was not a
black swan
The Engle experiment
I No complex products
Wrap-up
I No models
I No performance-related pay
I A leverage ratio
Although not all outcomes of such an approach are
undesirable, we risk ignoring the fact that the world has
changed and there effectively is no way back to the “good
old times”.
Lessons for us Is risk modelling
dead?
Maarten
Gelderman

Responses to the
crisis
Reform by nostalgia
Lessons for us

Modelling
How to evaluate model
shortcomings?
I Society wants more control Why the crisis was not a
black swan

I We need to communicate better The Engle experiment

Wrap-up
I It doesn’t help to deny model failures (“25σ”)
I Models are not reality
How to evaluate model shortcomings? Is risk modelling
dead?
Maarten
Gelderman

Responses to the
I Simplifications are only acceptable if they avoid crisis
Reform by nostalgia

worse simplifications, Lessons for us

Modelling
I Simplifications are not acceptable if they give the How to evaluate model

wrong incentives shortcomings?


Why the crisis was not a
black swan
I Gaming (even within organisations) The Engle experiment

I Wrong decisions Wrap-up


I Herding behavior
I Giving a false sense of security
I Intentionally misleading models are not acceptable
I Simplicifications are only acceptable if we
communicate about them openly
I A dillema: Is diversification beneficial for society?
Is the crisis a unique event? Is risk modelling
dead?
Maarten
Gelderman

Responses to the
crisis
Reform by nostalgia
Lessons for us

Modelling
How to evaluate model
shortcomings?
I Long-term perspective Why the crisis was not a
black swan

I Volatility and correlation The Engle experiment

Wrap-up
I What is a realistic number of outliers (the Engle
experiment)
0,000
0,005
0,010
0,015
0,020
0,025
0,030
0,035
0,040
08-02-1994
09-05-1994
05-08-1994
03-11-1994
01-02-1995
02-05-1995
31-07-1995
27-10-1995
25-01-1996
24-04-1996
23-07-1996
21-10-1996
17-01-1997
17-04-1997
16-07-1997
14-10-1997
12-01-1998
10-04-1998
09-07-1998
07-10-1998
05-01-1999
05-04-1999
02-07-1999
30-09-1999
29-12-1999
Volatility of returns

28-03-2000
26-06-2000

sd MSCI
22-09-2000
21-12-2000
21-03-2001
19-06-2001
17-09-2001

sd UKP/USD
14-12-2001
14-03-2002
12-06-2002
10-09-2002
09-12-2002

sd EUR/USD
07-03-2003
05-06-2003
03-09-2003
02-12-2003
01-03-2004
28-05-2004
26-08-2004
24-11-2004
22-02-2005
23-05-2005
19-08-2005
17-11-2005
15-02-2006
16-05-2006
14-08-2006
10-11-2006
08-02-2007
09-05-2007
07-08-2007
05-11-2007
01-02-2008
01-05-2008
30-07-2008
28-10-2008
26-01-2009
24-04-2009
crisis

black swan

Wrap-up
Lessons for us

Modelling

shortcomings?
dead?
Maarten

Reform by nostalgia
Gelderman

The Engle experiment


How to evaluate model

Why the crisis was not a


Responses to the
Is risk modelling
0,000
0,005
0,010
0,015
0,020
0,025
0,030
0,035
0,040
08-02-1994
09-05-1994
05-08-1994
03-11-1994
01-02-1995
02-05-1995
31-07-1995
27-10-1995
25-01-1996
24-04-1996
23-07-1996
21-10-1996
17-01-1997
17-04-1997
16-07-1997

sd MSCI
14-10-1997
12-01-1998
10-04-1998
09-07-1998
07-10-1998

sd UKP/USD
05-01-1999
05-04-1999
02-07-1999
30-09-1999
29-12-1999
28-03-2000

sd EUR/USD
26-06-2000
22-09-2000
21-12-2000
21-03-2001
19-06-2001
17-09-2001
14-12-2001

corr MSCI-USD/EUR
14-03-2002
12-06-2002
10-09-2002
09-12-2002
07-03-2003
05-06-2003
03-09-2003

corr UKP-USD/EUR
02-12-2003
01-03-2004
28-05-2004
26-08-2004
24-11-2004
22-02-2005
23-05-2005
19-08-2005
17-11-2005
15-02-2006
Volatility and correlation of returns

16-05-2006
14-08-2006
10-11-2006
08-02-2007
09-05-2007
07-08-2007
05-11-2007
01-02-2008
01-05-2008
30-07-2008
28-10-2008
26-01-2009
24-04-2009
0
1

-1
0,2
0,4
0,6
0,8

-0,8
-0,6
-0,4
-0,2
crisis

black swan

Wrap-up
Lessons for us

Modelling

shortcomings?
dead?
Maarten

Reform by nostalgia
Gelderman

The Engle experiment


How to evaluate model

Why the crisis was not a


Responses to the
Is risk modelling
-1
0
1

-0.8
-0.6
-0.4
-0.2
0.2
0.4
0.6
0.8
13/07/77
26/01/78
10/08/78
23/02/79
07/09/79
21/03/80
03/10/80
21/04/81
02/11/81
18/05/82
30/11/82
14/06/83
27/12/83
11/07/84
23/01/85
07/08/85
21/02/86
05/09/86
20/03/87
02/10/87
18/04/88
28/10/88
15/05/89
27/11/89
12/06/90
24/12/90
10/07/91
22/01/92
05/08/92
18/02/93

SD S&P 500
01/09/93
16/03/94
29/09/94
13/04/95
Quick and Dirty

26/10/95

S&P-30YR
S&P 500, 30YR T

10/05/96
21/11/96
09/06/97
19/12/97
08/07/98
21/01/99
05/08/99
17/02/00
31/08/00
19/03/01
05/10/01
23/04/02
04/11/02
21/05/03
03/12/03
Volatility and correlation of returns

21/06/04
03/01/05
19/07/05
01/02/06
16/08/06
05/03/07
17/09/07
02/04/08
14/10/08
30/04/09
0
0.01
0.01
0.02
0.02
0.03
0.03
0.04
0.04
0.05
0.05
crisis

black swan

Wrap-up
Lessons for us

Modelling

shortcomings?
dead?
Maarten

Reform by nostalgia
Gelderman

The Engle experiment


How to evaluate model

Why the crisis was not a


Responses to the
Is risk modelling
Lessons Is risk modelling
dead?
Maarten
Gelderman

Responses to the
crisis
Reform by nostalgia
Lessons for us

Modelling
I Don’t ignore older data How to evaluate model
shortcomings?
Why the crisis was not a
I Model volatility black swan
The Engle experiment

I Don’t look at average correlation Wrap-up

I Less volatility is not always less risk!


I Investigate correlation dependence on volatility
The Engle experiment Is risk modelling
dead?
Maarten
Gelderman

Responses to the
crisis
Reform by nostalgia
Lessons for us

Modelling
How to evaluate model
shortcomings?
Why the crisis was not a
I 2004 models black swan
The Engle experiment

I 2004 calibration Wrap-up

I ⇒ Outliers within acceptable limits


Is risk modelling
Using GARCH , DCC and extensions dead?
Maarten
S&P (Engle 2009) Gelderman

Responses to the
crisis
Reform by nostalgia
Lessons for us

Modelling
How to evaluate model
shortcomings?
Why the crisis was not a
black swan
The Engle experiment

Wrap-up
Is risk modelling
Using GARCH , DCC and extensions dead?
Maarten
High Low Book to Market (Engle 2009) Gelderman

Responses to the
crisis
Reform by nostalgia
Lessons for us

Modelling
How to evaluate model
shortcomings?
Why the crisis was not a
black swan
The Engle experiment

Wrap-up
Evalutation Is risk modelling
dead?
Maarten
Gelderman

Responses to the
crisis
Reform by nostalgia
Lessons for us

Modelling
How to evaluate model
shortcomings?
I Models gave the wrong incentives Why the crisis was not a
black swan

I Models gave a false sense of security The Engle experiment

Wrap-up
I Models were abused
I Better models were available
Wrap-up: how to kill a black swan? Is risk modelling
dead?
Maarten
Gelderman

Responses to the
crisis
Reform by nostalgia
Lessons for us

Modelling
I Be more humble and honest How to evaluate model
shortcomings?
Why the crisis was not a

I Communicate better black swan


The Engle experiment

I Leave more room for common sense Wrap-up

I Improve modelling: kill simple volatility and simple


correlation (and possibly the normal distribution)
References I Is risk modelling
dead?
Maarten
Gelderman
Robert E. Engle.
Responses to the
Anticipating correlations: a new paradigm for risk crisis

management. Reform by nostalgia


Lessons for us

The Econometric Institute Lectures. Princeton Modelling


How to evaluate model
University Press, February 2009. shortcomings?
Why the crisis was not a
black swan

Robert C. Merton. The Engle experiment

On the science of finance in the practice of finance: Wrap-up

Challenges and opportunities from the financial


crisis.
Van Lanschot Lecture, Tilburg University, 2009.
Riccardo Rebonato.
Theory and practice of model risk management.
Unpublished Working Paper, Royal Bank of Scotland
and Financial Research Center Oxford University,
2002.
References II Is risk modelling
dead?
Maarten
Gelderman

Responses to the
crisis
Reform by nostalgia
Lessons for us

Modelling
How to evaluate model
shortcomings?

Daniel K. Tarullo. Why the crisis was not a


black swan

Financial regulation in the wake of the crisis. The Engle experiment

Wrap-up
Speech at the Peterson Institute for International
Economics, June 2009.

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