Thursday, October 11, 2007

Trading at the extremes

So quant traders at Morgan Stanley lost $390m in a single day in August, helping to explain the $480m in losses reported by the bank for the third quarter. Morgan Stanley notched up 13 loss days, including four on which it lost more than $125m. But it also had eight days on which it made $125m or more, compared to the third quarter of last year when there was no day when it reaped more than $100m.

Same story, more success at Goldman. The Alea blog tells Goldman’s trading story in pictures, tracking its pattern of Q3 gains and losses over the past four years.

In the latest quarter, its distribution of winning versus losing days was as shown left: 18 down days, more than double that in the second quarter, but a massive 23 days earning more than $100m.

Contrast that with the pattern back in 2004 below, which shows more of a normal distribution, heavy in the middle and light on extreme outcomes.

While in 2007, trading losses in a single day on five occasions went over 95 per cent of the bank’s one-day value at risk, that situation never arose in the quarter three years before.

And we’re not talking about the same one-day VaR here. John Kemp at Sempra Metals noted at the time of Goldman’s last results that the bank’s appetite for trading risk continues to soar. Its gross VaR, before diversification effects, rose to $240m, up 6.2 per cent on the second quarter, and 42.9 per cent on the same three months of 2006.

The net VaR, including diversification effects across different assets traded, also rose to $139m in Q3 2007, from $92m the year before.

Kemp added that standard VaR calculations tend to understate the likelihood of large gains or losses and say nothing about the size of these gains or losses in the tails of the distribution. Plus diversification effects firm-wide become less significant in a crisis, where correlations tend to one - as the summer so aptly demonstrated.

He estimates that given these effects, assuming that extreme day profits and losses are a multiple of 99 per cent VaR, that the risk on Goldman’s books could be more than $500m. Which helps to explain how Morgan Stanley arrived at a $390m one-day loss in what was an exceptional quarter.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.