Letter: Bath salts analogy does not hold water
The Financial Times
From Mr Christopher Whalen.
Sir, In
his comment "The odds of finding a formula to foretell disaster"
(January 18), John Kay makes an amusing reference to the fact that the
equations discovered by Myron Scholes (and others,
more significantly, such as Robert Merton at Harvard and the late Fisher Black)
"to value complex derivatives securities also describe how bath salts
disperse in the tub".
This is not funny. The
dispersal of dissolved salts in water will, over time, equalise
in what could be described as a "normal" distribution. In the search
for rare events such as
Prof Kay writes that
"the scope and achievement of these theories are so great that it is a
shock when they do not work". Indeed. My question to our colleagues in the
financial world, who largely rely on Merton models to price derivatives, is why
any of us can confess surprise at the failure of risk measurement systems that
look for early warning by making generalisations
about events that are entirely particular and unique.
The Harvard professor Eric A.
Helfert, in his classic 1967 book Techniques of
Financial Analysis, notes that "the main purpose of financial analysis is
to provide reasonable clues and answers to specific questions posed by problems
of interest to the analyst. It cannot be overemphasised
that financial analysis (the use of analytic tools) is not an automatic or standardised process; rather, it is a flexible approach
tailored to the needs of the specific situation."
Whether you are looking for
earthquakes or financial restatements, using models that assume a normal
distribution of future events may deprive the analyst of that leisure time
required to enjoy a good soak in the tub.
Christopher Whalen
Managing Director
Institutional Risk Analytics