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Arthur Charpentier, ENSAE, PhD in Mathematics (KU Leuven), Fellow of the French Institute of Actuaries, professor at UQàM in Actuarial Science. Former professor-assistant at ENSAE Paritech, associate professor at Ecole Polytechnique and professor assistant in economics at Université de Rennes 1. Arthur is a DZone MVB and is not an employee of DZone and has posted 155 posts at DZone. You can read more from them at their website. View Full User Profile

Financial Model Complexity

05.01.2013
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Today, Olivier Scaillet gave a great talk on fast recursive projections. The idea was great, and the talk was amazing. A great plenary session talk actually. And after lunch, while we were having a coffee, we started to discuss about financial model complexity, mentioning that sometimes, traders and quants are lost, and it might be good to spend more time on basics than on very advanced stuff (which was, in fact, the general idea of my own talk, yesterday). And Olivier recalled that story, on how a rookie excel error led JPMorgan to misreport its VaR for years, published on the blog http://zerohedge.com/…. The short story is that the JPM’s reported VaR did rise by some 93% year over a year, from 2011 to 2012 (while it was decreasing for all competitors). The reason is explained in the very last page of its JPM task force report

… a decision was made to stop using the Basel II.5 model and not to rely on it for purposes of reporting CIO VaR in the Firm’s first-quarter Form 10-Q. Following that decision, further errors were discovered in the Basel II.5 model, including, most significantly, an operational error in the calculation of the relative changes in hazard rates and correlation estimates.Specifically, after subtracting the old rate from the new rate, the spreadsheet divided by their sum instead of their average, as the modeler had intended. This error likely had the effect of muting volatility by a  factor of two and of lowering the VaR…. It also remains unclear when this error was introduced in the calculation.

(Tyler Durden did highlight some parts, and I keep it like that). Let’s admit it: we did have fun about practitioners (actually, there was also a quant sitting with the two of us). But on the other hand, it is a bit scary, to see that we spend so much time to implement complex algorithms, to faster computations, and finally, we end up with a mistake in a spreadsheet….

Published at DZone with permission of Arthur Charpentier, author and DZone MVB. (source)

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