More Realistic Financial Models Incorporating Illiquidity And Leverage Are Needed

By CFA Institute:
By Mark Harrison, CFA
Opening the CFA Institute 65th Annual Conference in Chicago, behavioral investor James Montier condemned theorists, policymakers, and practitioners for creating the financial crisis with "bad models, bad policies, bad incentives, and bad behavior." Worse still, Montier contended, nothing much has been learned from the disaster - setting us up for yet another calamity.Montier began his talk by attacking key financial models. "In finance, we forget we have made abstractions and take the models as if they were reality," he said. Value at Risk (VaR), a popular measure of downside risk and potential loss, "cuts off the very part of the probability distribution (the extremes) which you most need to worry about." VaR - combined with leverage and naïve calculations about volatility based on overly recent data - has escalated institutional risk to the point that it has become systematic risk. "You are introducing an enormousComplete Story »