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Sai Waisiriroaj (napalak@thequantgroup.com)
September 2010 Anatomy Of A Black Swan: The Last Straw That Broke The
Camel's Back.
Black Swans are statistical aberrations - freak events - that are not suppose
to happen in our life time or sometimes even longer like in the opening
statement: twenty billion times twenty billion years! Yet Black Swan events
seem so ubiquitous and since the October 1997 crash, we offer glimpses of
the bird in their shapes and forms such as: 1997 Asian crisis, failure of
LTCM, 911, bursting of the dotcom bubble, the Tsunami in South-East Asia,
the Lehman crisis, and more recently the Greece sovereign debt crisis. And
in Thailand's own back yard: the riot in May 2010.
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In this essay we offer a thesis in recognizing their symptoms or a Young
Black Swan so to speak. We aim to explain the ubiquity of the Black Swans
through probabilities as well as fundamental analysis of Black Swan events.
The author of the book The Black Swan, Nicolas Nassim-Taleb, explains
Black Swan events to us using his two-worlds model. One world is a world of
averages or mediocrity and he calls this Mediocristan. Another world is world
of extremes and he calls this Extremistan. Nassim Taleb then purports to
illustrate that Mediocristan populations are for an example: people’s heights.
Sure, the Chinese NBA basketball superstar Yao Ming may be 7’6” tall and
most people are going to fall between five to seven feet. He’s hardly a Black
Swan. He’s just very tall. There won’t be someone who’s going to be 18 foot
tall. If you do find Big Foot, please come and claim your rewards. Other
examples in the world of Mediocristan include people’s weight, age, number
of hamburgers eaten per meal, numbers of aces served at Wimbledon and
so on.
“Big Foot”: Last seen somewhere in Oregon but Roger Patterson wasn’t close
enough to measure how tall he was.
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The world of Extremistan on the other hand consists of very extreme
variables like salaries and box office hits for examples. Bill Gates and Michael
Jordan making hundreds of million dollars or billions a year would skew the
average annual salaries. The movie Avatar grossed some US$2.8 billion and
probably trumped Big Foot - The Movie by at least 30,000 times. The world
of Extremistan have a larger population of Black Swans. And stock markets
by Nassim-Taleb is in the world of Extremistan.
Allow us to digress and show you Black Swan events in theoretical physics
and why they happen more than statisticians think. Theoretical physicists
have always wondered what it was like in the first few minutes of the Big
Bang some fourteen billion years ago. They theorize (Grand Unified Theory
or GUT) that the heat in first few seconds of the Big Bang was billions and
billions of (1028) degrees Kelvin and the infancy of the Universe was just an
extremely hot cosmic soup of elementary particles such as Quarks. Yes just
very hot soup -- no star, no earth, nothing solid -- just a big expanding hot
bowl of subatomic particles soup blended as roughly half matter (Quarks)
and half antimatter (anti-quarks). It was because of just one additional
elementary particle known as a Quark that tipped the balance of matter
being one Quark more matter than antimatter that gives us this "Quarkness"
enabling matters to form into stars, earth, suns, moons, people, plants,
elephants and what have you. This is The God Particle.
We owe our existence to this Quark so much so that scientists spend - here
it is again - billions and billions of dollars in search of understanding these
elementary particles. GUT theorizes that Quarks inside of protons almost
never brush pass each other to feel the Grand Unified forces but when they
do, the proton will decay into other lighter particles, namely, a Positron and
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a Neutral Pion which immediately decays into two Gamma Rays. The chance
of a decay of Proton is one out of 8.2 x 1033 years. This is billions and billions
of years. So a Proton decaying requires two Quarks to brush pass each other
is a Black Swan event for the Proton population.
The God Particle: Quarks brushing pass each is a Black Swan event for
subatomic particles
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Black Swan happening is very low: you are likely to die of old age by the
time you are 75 before you get to experience a plane crash. But there are
more than 10 million commercial flights in a year, therefore the probability
of hearing about a plane crash is slightly higher than once a year.
Water ranges from hot to cold. At two degrees Celsius, water is cold and at
one degree Celsius water is very cold. But at zero degree Celsius, it's no
longer water. It's ice. Ninety-nine degree Celsius and water is boiling hot but
at one hundred degrees, it's no longer water. It's steam. Zero and One
Hundred degrees Celsius are water's tipping points.
Look hard enough Black Swans are a lot like that. It tends to start off as a
Grey Swan and gets darker and darker. But its color transitions very
smoothly that people often overlook them until they turn into a Black Swan.
The switch from a Grey Swan to a Black Swan is the proverbial straw that
broke the camel's back. What may otherwise look like a ski slope can
disastrously turn into an avalanche due to that final snow flake.
Picture a Coca Cola bottle full of this black sugared water. Bacteria eat the
sugared water as food and breed by doubling every minute. It takes 60
minutes for the bacteria to finish the Coke and fill the whole bottle with
bacteria. So the question is: at which minute is the bottle half-full? The
obvious answer is "at the 59th minute."
Now imagine at the 59th minute, the prime minister of this bacteria
population standing on top of the pile of bacteria at half-way point in the
bottle downplays the problem that this Coca Cola bottle world is running out
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of foods and air by pointing out that there is as much space available as
there is bacteria population. One minute later, lights out for every bacteria.
This doubling effect is lethal. Plagues behave this way. And a plague is a
Black Swan.
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Figure 2: CDO Denomination
In the domain of finance and investments, both investors and issuers seem
oblivious to such steep rises of Non-Performing Loans (NPLs) on banks'
balance sheets, leverage on corporate balance sheets or stratospheric Price-
Earnings ratios of stock markets for examples. While at the same time, and
as often this is the root cause of these systemic risks, Central Banks were
seemingly oblivious to rising monetary stocks and monetary velocity that
caused the inflations of these asset prices. The first upticks of the stock
market fueled hope. The upward trend picked up momentum fueled by
greed which in turn pushed markets above rationality. Then something -
practically anything - spooked the market, and a precipitous fall followed.
The higher the stock market index, NPLs volume, or corporate leverage
moved up above levels of rationality, the harder the falls. The very very hard
falls are Black Swans.
Not all Black Swans are imported. We have seen these frictions in local
markets. In India, bombings and killings instigated by the Maoist Naxalites
are more ubiquitous in recent years. Take the ethnic Chinese in Indonesia.
Every now and then the friction particularly from the predominant local
Indonesians known as the Prebumi flare up against especially the much
wealthier minority Chinese. As many times though they flare up against
themselves or between the differing ethnic groups or simply flare up against
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their own government. In other South-East Asian countries such as the
Philippines and Malaysia, the Chinese minorities have been the subject of
envy over their wealth and a source of friction from the indigenous
populations. Thailand has its own split between the Red Shirts and The
Yellow Shirts which are mostly about income disparities dressed as clashes
of classes and seems to be mostly politically-driven. It is also interesting to
note that six out of seven Russian Oligarchs are Jewish and there has been
much resentment of and violence towards the Jewish minorities in Russia.
These are grey swans that could potentially turn into Black Swans. Whether
these grey swans turn black is dependent on whether they gather enough
momentum to reach their Tipping Points – the last straw that breaks the
camel’s back.
Pakpoom Vallisuta and Sai Waisiriroaj are co-founders of The Quant Group. Pakpoom is
Chairman of the firm and is a board member of Duke University’s Fuqua School of Business.
Sai is Managing Partner of The Quant Group and has an MBA from The University of
Chicago.