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SSRN-Errors, Robustness, and the Fourth Quadrant by Nassim Taleb

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Another paper written by NNT. PDF available for download at link location.

Errors, Robustness, and the Fourth Quadrant


Nassim Nicholas Taleb
NYU-Poly Institute; London Business School

February 14, 2009


Abstract:     
The paper presents evidence that econometric techniques based on variance- L2 norm are flawed -and do not replicate. The result is un-computability of role of tail events. The paper proposes a methodology to calibrate decisions to the degree (and computability) of forecast error. It classifies decision payoffs in two types: simple payoffs (true/false or binary) and complex (higher moments); and randomness into type-1 (thin tails) and type-2 (true fat tails) and shows the errors for the estimation of small probability payoffs for type 2 randomness. The Fourth Quadrant is where payoffs are complex with type-2 randomness. We propose solutions to mitigate the effect of the Fourth Quadrant based on the nature of complex systems.

SSRN-Finiteness of Variance is Irrelevant in the Practice of Quantitative Finance by Nassim Taleb

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Paper written by NNT.

Finiteness of Variance is Irrelevant in the Practice of Quantitative Finance


Nassim Nicholas Taleb
NYU-Poly Institute; London Business School

June 09, 2008


Abstract:     
Outside the Platonic world of financial models, assuming the underlying distribution is a scalable power law, we are unable to find a consequential difference between finite and infinite variance models – a central distinction emphasized in the econophysics literature and the financial economics tradition. While distributions with power law tail exponents α>2 are held to be amenable to Gaussian tools, owing to their finite variance, we fail to understand the difference in the application with other power laws (1<α<2) held to belong to the Pareto-Lévy-Mandelbrot stable regime. The problem invalidates derivatives theory (dynamic hedging arguments) and portfolio construction based on mean-variance. This paper discusses methods to deal with the implications of the point in a real world setting.