The Economics Book

265

Black swans are rarely sighted

but do exist. Nicholas Taleb refers

to the highly unexpected, extreme

movements of the market as

“black swan events.”

CONTEMPORARY ECONOMICS

into the pricing model to generate
“implied volatilities.” This created
a new way to manage risk: instead
of trading on the basis of prices
or expected prices, portfolios of
assets could be put together
directly on the basis of their
riskiness as implied by the market
price. Risk itself, as described by
the mathematical models, could
be traded and managed.

The 2008 crash
The explosion in financial innovation,
aided by sophisticated mathematics
and ever-increasing computing
power, helped drive the
extraordinary expansion of the
financial system over several
decades. From negligible amounts
in the 1970s the global market for
derivatives grew on average by 24
percent a year, reaching a total of
$596 trillion by 2008—about 20
times global GDP. Applications
multiplied as firms found apparently

Low risk, high rewards

US-Lebanese economist

Nicholas Taleb claims that by

underestimating the risk of

extreme price movements,

the apparently sophisticated

financial models overexposed

investors to the real risk.

Collateralized debt obligations

(CDOs) are a prime example.

These are financial instruments

that raise money by issuing

their own bonds before

investing that money in a

mixture of assets such as

loans. CDOs took on the risks

of very low-quality (subprime)

housing debts that had a high

chance of defaulting, and

mixed them with high-quality

debt, such as US Treasury

bills. They apparently offered

low risk and high rewards. But

this relied on an assumption

that the combined risk of

default followed a normal

distribution pattern and

was stable. As US subprime

mortgages defaulted in

increasing numbers, it became

clear that this assumption did

not hold, and the enormous

CDO market imploded.

secure, profitable new ways to

manage the risks associated

with lending.

By September 2008, when the

US investment bank Lehman

Brothers filed for bankruptcy, it had

become clear that this expansion

had fatal weaknesses. Critical

among these was the dependence

on the assumption of a normal

distribution: the idea that most

prices cluster around an average,

and extreme price movements

are very rare. But this had been

disputed as early as 1963, when

French mathematician Benoît

Mandelbrot suggested that extreme

price movements were much more

common than expected.

Post-crash, these models are

being reexamined. Behavioral

economists (pp.266–69) and

econophysicists use models and

statistical techniques drawn from

physics to better understand

financial markets and risk. ■

In the years leading to the 2008 crash, banks assumed that investment risk
followed a “normal distribution” pattern (the blue line), where there is a high
probability of making a small gain, and a very low probability of making an
extreme gain or loss. However, investment risk actually follows a different
pattern (the dotted line), in which extreme events are far more common.

LOSS GAIN

FREQUENCY OF EVENTS

High

probability,

small gain

Low

probability,

big loss

0

Low

probability,

big gain