What’s Wrong with Risk Models?

April 27, 2010, The New Yorker

First up, sincere apologies to the organizers and attendees of the Milken Global Forum, in Los Angeles, where I was due to appear this afternoon at a session about economic models of risk. I was looking forward to engaging the other panelists, who included Nobel laureate Myron Scholes, of “Black Scholes” fame; Colin Camerer, a Cal-Tech behavioral economist I’ve written about in the past; and Aaron Brown, a former Wall Street risk modeler.

What went wrong? It is now commonly said that the reason the models, especially the Value-at-Risk models, came a cropper is that they didn’t account for the possibility of “fat tails.” This is Nassim Taleb’s “black swan” critique, which goes back to Benoit Mandlebrot’s work in the early nineteen-sixties.

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