The limits of models

John Kay has an excellent piece in the FT about the limits of risk models. As he points out, they are no use for risks that they don’t model. In particular, if they are modelling financial risks, and are calibrated using recent data, they are no use at all for modelling major phase changes.

For example, a risk model for the Swiss franc that was calibrated using daily volatility data from the last few years was pretty useless when the franc was un-pegged from the euro. Such a model made a basic, probably implicit assumption that the peg was in place. It was therefore not modelling all the risks associated with the franc.

As Kay puts it,

The Swiss franc was pegged to the euro from 2011 to January 2015. Shorting the Swiss currency during that period was the epitome of what I call a “tailgating strategy”, from my experience of driving on European motorways. Tailgating strategies return regular small profits with a low probability of substantial loss. While no one can predict when a tailgating motorist will crash, any perceptive observer knows that such a crash is one day likely.



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