Sunday, October 19, 2008

Black Swans and the inherent flaws of structured products.

Some of the structured products (e.g. DBS HN5) are just down right bad even without the inherent flaws I'll be discussing.

About 2 years ago, I ordered a book from shipped from entitled "Fooled by randomness". I got interested in the book after reading a few articles by the author Prof. Telab. His theory was that a lot of the financial engineering models are flawed because of the "fat tails" that occurs in reality that is not (and cannot be) modeled in financial engineering. A fat tail probability distribution means that large movements and catastropic events occur with a far higher probability than in normal distributions used by financial engineers. Black Swan events are a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations (wiki). Because they are not modelled in financially engineered products, these products in reality carry far higher risks than what is designed. In other words, the products are flawed like bad medicine with potent side effects discovered only after they are sold to millions.

Almost all structured products sold in Singapore are linked to derivatives. Purchasers of structured products unknowingly become buyers/sellers of derivatives. I believe there is little use for these products and nobody actually needs them except those who make money selling them - the commission earners, banks etc. What do we lose getting rid of these products? Nothing really....Do you know why there are no minibonds protests in Malaysia? The Malaysian MAS took a look at these products couldn't understand them and decided not to allow these products to be sold to retailers at the banks. That decision saved thousands of Malaysians from the pain of losing their lifesavings. They do not have high flying scholars from Princeton or MIT but they have people with common sense not to allow risky complex products to be sold to ordinary citizens. That common sense saved their citizens from the suffering that 10,000 Singaporeans are experiencing right now.


Anonymous said...

Well, it's easy for you to compliment the M'sia govt on hindsight. Singapore, on the other hand, has to contend with other regional financial centres such as Hong Kong.

LuckySingaporean said...

Yes, all else has to be traded off for our aspirations to be a financial hub even the life savings of Singaporeans.

Anyway this thing is turning out to be far far bigger than Mas Selamat. If they mis-step on this issue, the damage is permanent. Everything they have done seems to show they are talking from 10,000 feet. SM Goh will have a chance on Monday - hear him out. I hope for his sake, he doesn't turn out disappointing.

tewniaseng said...

Malaysia Govt is wiser than Spore Govt. In Spore ministers are paid millions of dollars, MAS chairman can't figure out the risks involve. So bloody stupid, you call this super talented minister ? Pui better retrench them. MAS ( Mana Ada System )

Anonymous said...

Nice topic... Lucky, maybe you can extend this topic a bit more?

One could also ask why is it so hard to predict whether we when we will come out of a recession (since we are into a tipping pt.). In normal circumstances, the market function within its limitation, that is to say its predictability relies on the system being linear and deterministic, you can read the fundamentals and follow the technical trend-line, you can even argue the minority irrational behaviour of investor cancels out because of its randomness (hence the in the long run, trend-lines adhere to fundamentals).

When observing the dynamics of a system we ALWAYS assume the absence of the so called butterfly effect, even though we have known this peculiarity since Newton theorised classical mechanics.

One could also observe that sensitivities increases when you drive a linear system towards the non-linear limit. Be it rapid growth in economies, the amount of CO2 that is pumped into the atmosphere, crashing planes into tall buildings...

Maybe it is just in our nature that we want a bit certainty in life.

ted said...

Thought you may like to check out this blog's author's thoughts:

Anonymous said...

Hi Lucky Tan,

Brilliant post as usual! Just one comment though. They (Malaysian MAS) do have high flying scholars too. Malaysia and Singapore govts share the same "Elite Mandarins" ideology. They are alike more than they would like to believe kekeke.


Economist with a Heart :)

Anonymous said...

"Malaysia Govt is wiser than Spore Govt."

Not that malaysia govt is wiser but it is lazy. So lazy that it did not approve the Lehman's scam product because it takes so much time and effort to understand and study the scam product. Rather the government find it more constructive, exciting and productive to screw Anwar and accuse him of sodomy instead. Because of this 'luck', therefore save them the financial massacre. As even fools have their good days so because of laziness, the malaysia govt is better off this time and can now happily laugh at singapore gov for being stupid and moron.

Moral: It pays to be lazy especially when it comes to approving complex product.

Learn that, Singapore government, and stopping screwing the citizen !

Anonymous said...

The differing responses can be traced back to the priorities of the 2 govts in question. One is accountable to the people because it knows it can be removed from power if the voting majority go against it. Hence, good move protecting the voting public.
The other is only interested in growing the economy, not votes (as they so clearly stated in the papers). Why do you think the CPF Investment Scheme was introduced? To benefit citizens? No, rather it was to attact foreign investment houses - with the honeypot of an opportunity to sell crappy unit trusts with 5% upfront sales charges and 2% annual mgmt fees to gullible S'poreans!

Anonymous said...

I believe the Singapore MAS also cannot catch no BALL about this structural products.

They just wanted to please Lehman Brothers and to attract it to build its asia pacific HQ in Singapore. You can easily google for Lehman & Singapore to realize their economists have been sprouting nonsense, e.g., speculating about the property in Singapore when they can't even handle their property back home in US.
Singapore just loved to be screwed in the ass by big-names

ST DB said...

If more fools undermine the legal AND moral implications of a binding contract, we should have fools who lose money on stocks and property when stock or property price go down protesting that they were cheated and it's the govt fault they lose money in life ok??? Lawyers will go out of business and the whole society will crumble because who knows?

I dun like after I sign contract and lose money is ok can protest or blame govt.Still can undo what my 'mistake'.

All the people who ever lost a cent in stock, properties and business ventures also can complain.

Kura-kura said...

Unintended benefits of
Malaysia being a tortoise

Anonymous said...

Very top civil servants (think admin service league) told me about the Black Swan theory and they told me that a fresh 25 yr old AO would have been taught that. Separately a 25 yr old AO told me he was taught that by the govt.

You fools. You don't know what you are dealing with, and it's many light years smarter than you. So pathetic!

laucheow said...

Bravo! This is a great post - and FbR is one of my favorite books too. Created a lot of controversry on Wall St when it first appeared years ago; everybody read it, thought they understood it and now all this comes to pass. Which goes to show nobody still understands risk and uncertainty. BTW, Taleb's second book came out in 2006, it's now in paperback and entitled The Black Swan. Get it, read it, and then read FbR again. It argues even more forcefully about the unpredictability of life and the markets, about how we don't understand and mismanage risk, and why all those Econs and Finance MBAs are wrong with all their theories based on faulty assumptions. And then when you add human gullibility and greed to this you have a disaster of epic proportions in the making...