Thursday, August 28, 2008

Why you can’t stop bubbles

Now that we are in the recrimination phase of the cycle, we are seeing more and more of what happened and how do we stop it happening again questions and investigations. While the article focuses on Europe, a parallel process is occurring in the US.

Asymmetric payoff is the problem
I would humbly submit that it is virtually impossible for stop excesses from recurring in a capitalist society. As one quote from a risk manager put it:

…the job we do has the risk profile of a short option position with unlimited downside and limited upside. This is the one position that every good risk manager knows he must avoid at all costs.

Remember the IPO allocation scandals from the last cycle? There were all sorts of controls put into place. In the next cycle, excesses popped up elsewhere. That’s because of the asymmetric nature of risk. Risk managers have are burdened with short option position phenomena in risk control: limited upside and unlimited downside. On the other hand, revenue producers (whether in a hedge fund, broker, or other financial services entity) have the reverse position of being long a call option. These people get handsomely rewarded by making money for their firm and for themselves through financial engineering, but they face limited downside risk if the structure they build all comes apart at some point in the future.

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