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Fourth Quadrant

This is a slightly more technical Version of the 2010 BT Lecture, Oxford University, July 14,

2010. This can also be used as a second technical companion to the essay On Robustness

and Fragility in the second edition of The Black Swan (the first one being the Fourth

Quadrant). I also introduce a simple practical method to measure (as an indicator of fragility)

the sensitivity of a portfolio (or balance sheet) to model error.

BACKGROUND

the knowledge about of small probabilities, both

empirically (interpolation) and mathematically

(extrapolation)1 , and its consequence. This discussion

starts from the basis of the isolation of the "Black Swan

domain", called the "Fourth Quadrant" 2 , a domain in

which 1) there is dependence on small probability

events, and 2) the incidence of these events is

incomputable. The Fourth Quadrant paper cursorily

mentioned that there were two types of exposures,

convex and concave and that we need to "robustify"3

though convexification. This discusses revolves around

convexity biases as explaining the one-

the opposite. By Jensen's inequality, if we use for Thus as an illustration of the payoffs in Figure 1, take

function the expectation operator, then the expectation the distribution of financial payoffs through time; a

of an average will be higher than the average of portfolio that has a floor set at K would have the

expectations. −K

downside shortfall S = equaling 0. I have

∫ x f (x) dx

E ∑ f (ω i Xi )) > ∑ ω i E f (Xi ))

been calling such operation the "robustification" or

"convexification" of the portfolio, making it immune to

TWO TYPES OF VARIATIONS (OR PAYOFFS) any parameter used in the computation of f(x).

mathematical discussion to come later.

errors.

Figure 1 Concave payoff through time, with

respect to a source of variation; or concave The typical concavity, and the one that I spent my life

errors from left-skewed distributions. immersed in, is the one with respect to small

probabilities, as will be discussed a bit later.

Robustness and Convexity: As we can see from

Concave to model error: when payoff is negatively Figure 2, convex systems will mostly take small insults,

skewed with respect to a given source of variations; the for massively large gains, concave ones will appear

shocks and errors can affect a random variable in a more stable.

negative way more than a positive way, as in Figure 1.

It is the equivalent of being short an option Generalization to Other Areas:

somewhere, with respect of a possible parameter. As

we will see, even in situations of short an option, there WHERE ERRORS ARE SIGNIFICANT

may be an additional source of concavity. A concave

payoff (with respect to a source of variation) would

Projects: This convexity explains why model error

have an asymmetric distribution with thicker left-tail.

and increased uncertainty lengthens rather than reduce

A conventional measure of skewness is by taking the expected projects costs and duration. Prof Bent

expectation of the third moment of the variable, Flyvbjerg, owing to whom I am now here, has shown

x3,which necessitates finite moments E[xm], m>2, or ample empirical evidence of that effect.

adequacy of the L2 norm which is not the case with

Deficits: Why uncertainty lengthens, doesn't

economic variables. I prefer to use measures of

shorten deficits. Deficits are convex to model error; you

shortfall, i.e. expectation below a certain threshold K,

−K can easily see it in governments chronic

∫ x f (x) dx compared to ∫ x f (x) dx , K being a remote

K

underestimation of future deficits. If you run into

anyone in the Obama administration, particularly Larry

threshold for x the source of variation. Summers, make them aware of it —they don't get the

point.

Convex to Variations and Model Error: the

opposite, as shown in Figure 2. Economic Models: Something the economics

establishment has been missing is that having the right

Note that whatever is convex to variations is therefore model (which is a very generous assumption), but

convex to model error –given the mathematical being uncertain about the parameters will invariably

equivalence between variations and epistemic

uncertainty.

lead to an increase in model error in the presence of deemed "expensive", or those with high growth, but

convexity and nonlinearities. low earnings, would markedly increase in expected

value, something the market prices heuristically but

As an illustration, say we are using a simple function

without explicit reason.

( ) , where α is supposed to be the average

f x, α

DISTRIBUTIONAL FAT TAILS AND CONVEXITY

expected rate α = ∫ α φ (α ) dα . The mere fact that α

is uncertain might lead to a bias if we perturbate from I've had all my life much difficulty explaining the

the outside (of the integral). Accordingly, the convexity following two points connecting dots:

bias is easily measured as

1) that Kurtosis or the fourth moment was

∫ f (α , x) φ (α ) dα − f (x, ∫ α φ (α ) dα ) equivalent to the variance of the variance; that the

variations around E[x2] are similar to E[x4].

As an example let us take the Bachelier-Thorpe option 2) that the variance (or any measure of

equation (often called in the literature the Black- dispersion) for a probability distribution maps to a

Scholes-Merton formula7). I use it in my class on model measure of ignorance, an epistemological concept. So

error at NYU-Poly as a platform to explain the effect of uncertainty of future parameters increases the variance

assuming a parameter is deterministic when in fact it of it; hence uncertainty about the variance raises the

can be stochastic8. kurtosis, hence fat tails. Not knowing the parameter is a

A call option (simplifying for absence of interest rate) is central problem.

the expected payoff: The central point behind Dynamic Hedging (1997) is

∞ that if one has uncertainty about the variance, with a

C(S0 , K, σ ,t) = ∫ K

(S − K ) Φ(S0 , µ, σ t ) dS rate of uncertainty called, say V(V) (I dubbed it

"volatility of volatility"); the higher V(V), the higher the

Where , where Φ is the Lognormal distribution, So is the kurtosis, and the fatter the tails. Further, if V(V) had a

initial asset price, K the strike, σ the standard deviation, variance called V(V(V)), which in turn had uncertainty,

and t the time to expiration. Only S is stochastic within all the way down, then, simply, one ends with Paretan

the formula, all other parameters are considered as tails. I had never heard of Mandelbrot, or his link of

descending from some higher deity, or estimated Paretan tails with self-similarity, and I needed no fractal

without estimation error. argument for that. The interesting point is that mere

uncertainty about models leads immediately to the

The easy way to see the bias is by producing a nested necessity of use of power laws for epistemic reasons.

distribution for the standard deviation σ, say a

Lognormal with standard deviation V then the true We already saw from the point that options increase in

option price becomes, from the integration from the value, with an effect called the "volatility smile".

outside:

∫ C(S , K, σ ,t) f (σ ) dσ

0

operators who price out-of-the-money options, the

most convex, at some premium to the initial Bachelier-

Thorpe model, a relative premium that increases with

the convexity of the payoff to variations in σ.

Corporate Finance: Without getting into the details

here, corporate finance seems to be based on point

projections, not distributional projections; thus if one

perturbates cash flow projections, say, in the Gordon

valuation model, replacing the fixed —and known—

growth by continuously varying jumps (particularly

under fat tails distributions, on which, later), companies

8 I am using deterministic here only in the sense that it is

not assumed to obey a probability distribution; Paul

Boghossian has signaled a different philosophical meaning to

the notion of deterministic.

(To come in the second version)

COMPARATIVE TABLEAU OF ROBUSTNESS

FILLING IN THE TAIL OF A DISTRIBUTION

FRAGILE ROBUST

WHY IS LARGE FRAGILE?

Optimized Redundant

HOW TO MEASURE TAIL ERRORS: TWO

METHODS OF PERTURBATIONS

Model Heuristic

Rationalism Empiricism/Reliance

REDUNDANCY, PARTICULARLY DEGENERACY

(economics modeling) on tested heuristics

(EDELMAN-GALLY) AS OPTION

Nation state City State INTERVENTION (VENTER)

--centralized -- decentralized

Debt Equity

Large Small

Monomodal Barbell

Derivative Primitive

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