Essentials of Financial Risk Management by Horchen K

By Horchen K

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The bridge lasted just four months, and it failed in winds less than half the 100 miles per hour for which it was designed to withstand. The dramatic collapse was captured on film, so the world saw the images repeated over and over in newsreels. Suspension bridges had become longer and thinner in the decades before the Tacoma Narrows collapse in 1940. The George Washington Bridge, spanning the Hudson River into New York City, epitomized this trend. Built according to the most advanced theories, it had doubled the length of the longest suspension span extant before its 1931 completion.

Table values in bold are t-statistics of at least 2 in absolute value. March 2008 seemed to be a particularly unlucky month for convertible arbitrage funds, according to the table, as returns were extremely unlikely. Yet things worsened: September and October were greater than 10 standard deviations to the downside. The corporate bond fund and the S&P 500 returns were also much larger in absolute magnitude than history would suggest, so perhaps some of these shocking moves were simply volatility increasing above the unconditional levels.

Subprime and Alt-A residential mortgages occurred, it became apparent that the historically calibrated correlation patterns were far from indicative of future joint default behaviors, and “tail-end probability” or “conditional/ regime-dependent” models were built “in a hurry” in an effort to replace the original pricing models. For many investors this came unfortunately too late. As prices collapsed (also driven by the new pricing models’ results) and investors lost confidence in the pricing models, they scrambled to liquidate as many securities as they could, which triggered an imbalance in supply and f or e w or d demand in secondary markets, which further depressed both the liquidity and the values of the inventories in such tranches.

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