JP Morgan Meets the Black Swan

Antony — May 17, 2012

The recent news of JP Morgan’s $2 Billion trading loss is another example of a Black Swan event, discussed in our book club’s current book. It appears that traders at the bank used complex econometric models to make market predictions, then hedged their bets using a negative carry trade, which means that maintaining the position cost them money over time. Rather then just accept these small losses as a cost of doing business, they kept increasing their bet in order to recoup the losses they had built up, known a Martingale betting strategy. As time went on, economic events deviated from their model assumptions in ways that they did not expect (the Black Swan), and the losses multiplied. This episode has exposed the inept risk management at the bank. And now that other traders know of JP Morgan’s vulnerable position, they are attacking them, “squeezing” their position.

The interesting strategy devised by Taleb was to take the other side of the trade. Realizing the distorted risk perception of most traders, he will take the psychologically uncomfortable position of accepting many small losses in hopes of occasional large wins that more than compensate for the losses. His method is described in this Malcolm Gladwell article.

These events are good illustrations of a basic tenet of Austrian Economics: There are no constant in human action. This is why econometric models can never work. As soon as you make assumptions that variables will stay within certain parameters, and begin acting on those models, the assumption will be violated, and the model blows up. This is why the Phillips Curve does not work when applied to public policy. It is the mistake that blew up Long Term Capital Management in the 1990′s. And it is the reason why economics cannot be understood using empirical methods, but must use a deductive approach, developing causal linkages based on a priori axioms.

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