Extreme Events in Finance

Chapter 20Protecting Assets Under Non-Parametric Market Conditions

Jean-Marie Choffray^1,2 and Charles Pahud de Mortanges²

¹Management Science Department, University of Liège, Liège, Belgium

²Marketing Science Department, ESSEC, Cergy-Pontoise, France

Under non-parametric market conditions, investors usually become more concerned about the return of their money than about the return on their money. Protecting assets becomes the surest if not the only path to survival and growth. High frequency trading systems, over leveraged shadow entities, flash crashes, and stealth central bank actions, to name a few, contribute to create a “Rumsfeldian” type of world in which decision makers have to cope not only with “Known knowns” – things they know that they know – but also with “Unknown unknowns” – things they don't know that they don't know! The goal of this paper is to explore such a conceptual model of the “Unknown” and to derive from it a concise and coherent set of battle-tested heuristics aimed at designing effective investment strategies to protect assets.

The typical state or mankind is tyranny, servitude and misery.

–Friedman (1962).

The last 10 years have witnessed a major acceleration in the pace of change in the world of investing. The synthetic nature of the assets involved, the fragmented structure of the markets on which they are exchanged, and the virtual form of most Internet-based transactions, to name a few, contribute to the emergence of a new reality. These changes ...