Captain Renault, actuary

I’m shocked – shocked! – that daily stock returns don’t follow a normal distribution. And so is Bjarne Graven Larsen, chief investment officer of Denmark’s biggest pension fund, ATP.

Short story: Larsen’s crew looked at daily investment returns since 1/1/06 and found two trading days with nasty dropoffs – 7% and 8.7%. According to the distribution ATP was using, you should see the former once every 1,500 years and the latter once every 450,000 years. Having both occur in a four- or five-year span means its time for a new model.

I’ve reproduced his chart below. The normal curve is the blue line – the model. The orange bars are the empirical distribution – what actually happened. When the orange bars extend above the line, it means the result occurred more often than the model predicted it would. And the zoomed-in shot shows how the model missed predicting those bad boys on the left.

Shocking

Their model also underestimated how often the market is boring – moving only a sliver up or down. You can see that in the middle of the chart. And he doesn’t mention it, but if you look to the right, the model also underestimated favorable days.

Larsen’s point: All market hedges are underpriced, because nobody’s model anticipated how likely such extreme movements are.

All a bit of a chuckle for casualty actuaries, who long ago stopped using normal distributions to model losses, preferring the fat tail of the lognormal (or even fatter tails, if we can get away with it).

Larsen, therefore, is sanguine about the extra capital Solvency II’s standard model would require. S-II’s model would require you to hold capital for a one-in-200-year blowout, but its curve likely has the same problem that ATP’s had. That would imply that S-II underestimates how much capital a company should hold, though Larsen doesn’t go so far as to say that. He does say this:

It turns out our risk model is far more conservative. But if a firm were to rely solely on the standard [Solvency II] formula they might run into some problems.

This all comes via risk.net.

Advertisements
Tagged ,

2 thoughts on “Captain Renault, actuary

  1. Lyle says:

    Proves that Taleb’s basic theisis is right the normal distribution in finance is a case of figures don’t lie but liars figure. Taleb points out that the 1987 crash is only supposed to happen every 20million years or so. Just like house prices in the us were never supposed to go down nation wide at the same time. Nature is fractal and we need to start using fractal models which greatly fatten the tails, when will the “experts” realise this? (Of course it means that financial life is more risky than everyone thought)

  2. […] motivated primarily by money and prestige. I also point to the quality of banking models (they seem yet to discover the lognormal […]

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: