Financial Theorist Links Extreme Events in Nature to Extreme Events in the Markets

April 4th, 2010

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Research led by Dr. Loran Chollete at the Norwegian School of Economics and Business Administration and Columbia University has found an interesting connection between extreme events in finance and extreme events in nature. Dr. Chollete and his team argue that the case of “anomalously low returns” for highly volatile and risky stocks can be explained using a simple statistical model common in describing natural disasters, such as extreme hurricanes and earthquakes. Dr. Chollete draws a parallel between governments that lack effective emergency response programs in the face of a natural disaster to investors who do not include “extreme event” risk strategies in their portfolios. “It is costly to investigate the changes in the financial climate,” said Dr. Chollete during a lecture at New York University’s Henry Kaufman Management Center this March. As a result, “investors are less likely to be prudent.” Dr. Chollete holds that many important lessons can be learned from the great recession of 2009, and it is essentially up to society to monitor and analyze the potential crises of these “small probability events.” Dr. Chollete concluded his presentation with a discussion of the “sustainability” of financial systems. A “sustainable” market as such would be resilient to extreme events by supporting a framework that monitors market signals to determine whether the current financial conditions have impending disastrous consequences. This “sustainable” aspect of the market would protect society from extreme events in finance—but perhaps not so much from earthquakes.