Money world

Professor Zari Rachev scorns the idea that market cataclysms cannot be forecast. He says his statistical models have predicted them, and his customers agree.

His daughter is now president of New York-based company FinAnalytica, which uses his models to provide investors and risk managers with a risk indicator that takes into account the worst-case scenarios.

As those who have so far survived the financial crisis pick over the wreckage to develop enhanced predictors of market risk, Rachev’s are among the offerings for people who believe statistical models can help.

“This past year was very important for us, because it validated everything that we worked for,” Boryana Racheva-Iotova told Reuters by telephone from Bulgaria.

Her firm’s risk measure, fat-tailed expected tail loss or ETL, gave investors advance notice of a sharp fall in the Dow Jones Industrial Average among other markets: the Dow fell from a life high in November 2007 to a 12-year low in March 2009, sliding sharpest after Lehman Brothers failed in September 2008.

Fat-tailed ETL builds on the statistical phenomenon popularized by former options trader Nassim Nicholas Taleb’s focus on the massively unexpected.

Think of a bell curve on a statistician’s chart that reflects “normal distribution.” It is tall and wide in the middle — where most events fall — and drops and flattens out at the edges, where fewer things happen, making a shape on a graph like a bell. When the edges or tails swell, instead of nearly vanishing, they are called “heavy” or “fat.”

Streams of financial commentators have over the past year reveled in a desire to present the crash as coming out of the blue to math whizzes paid a fortune to study the statistical stars and presage such events easy payday loans.

But Rachev is one of those who say they saw it coming — because his models took the worst possible events into account.

DEPARTING FROM VAR

In the case of the Dow Jones index, his fat-tailed expected tail loss — a measure of the potential daily average loss in the worst 1 percent of scenarios — gave investors notice of rising risk.

Boston-based Henderson Capital Management, which does not disclose its funds under management, said it used FinAnalytica models to help identify investment funds with significant downside risk through 2008.

“Some of these managers subsequently suffered large losses,” Managing Partner Mark Pearl said in a statement for Reuters. One is now closing down, he added, declining to name it.

With the Dow Jones in the three years to late 2006, the fat-tailed ETL was below 2 percent, but it started to rise in 2007 to 4 percent in March, then 8 percent in April 2008 and 10 percent in mid-September 2008.

By contrast, a typical Wall Street indicator that takes into account all cases but the worst 1 percent — known as value at risk (VaR) 99 — was signaling potential daily losses of no more than 2 percent until April 2008 and 5 percent in late-September. 

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