Managing Extreme Financial Risk

Chapter 5

Usefulness and Limits of Quant Models

Abstract

Despite the sophistication of quant risk-management models, they do not address the entire scope of uncertainty, and particularly the unquantifiable uncertainty that gives rise to extreme tail risk. A key factor is the inability to predict timing. Some models can explain long economic cycles. Basel III attempts to incorporate cyclicality into its models. However, a cycle–by definition–has normality, and thus all such models depend upon normality. The events of 2008 proved that crises occur more frequently, losses are more severe than VaR estimates imply, and an economic crisis is beyond normality because of nonlinearity. Chaos theory, order, and fractals are about discovering patterns ...