Friday, April 11, 2008

When you Ass-u-me....

You know the old saying about what happens when you assume. You make and a** out of you and me. Yeah, yeah, I put asterisks in there for decorum's sake (or were they assterisks?). Here is a chat room post stolen verbatim without the knowledge of the poster, Ron Davis. Ah, the joys of the digital age!

As follows:

The market meltdown of 1987 had as a major contributor the failure of "market insurance." Market insurance was based on the assumption of continuity of price which can also be seen as liquidity at each step, up or down, of price. We all recall that the assumed continuity evaporated.

LTCM, in addition to having Godzilla-like leveraging, assumed within their models continuity of liquidity.

Bear Stearns had pretty much the same model and assumption set, nearly as I can tell, as LTCM, just a different marketplace.

The rather large swap market appears to have much of the assumption of continuity built into the risk analysis.

VAR assumes continuity.

Implicit in the above, the Black-Scholes-Merton model assumes continuity, as well as constant price variance (risk in that view) and independence of markets, regardless of situation.

While I understand and can agree with the "let's assume continuity for our model" (if one's model requires that assumption), I urge members of this list to go back at least once a month and ask selves "what happens if there is a sizable hop (discontinuity)."

It's me again - well, what are you assuming about the market today? All of these ultra short and even ultra long ETFs, and the gold and oil ETFs for that matter, scare the pants off me because no matter what lab testing the sponsors have done, none of them have ever been testing in real life in a real melt-up or melt down.

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