Hark — the standard deviation devils sing (again).
As Reuters columnist John Kemp pointed out yesterday, recent swings in the commodities complex have produced some impressive probabilities figures. The kind you can wheel out in dinner party conversation. For instance, front-month Brent crude futures sank almost $12 per barrel (or over 9 per cent) on Thursday, leading the market down from over $120 at the start of the day to under $110.
That’s a price change of more than four standard deviations — which is a statistical way of saying it’s something that should be seen on average only once in every 63 years, assuming a normal bell-curve distribution. Kemp also points out that at times on Thursday the move also approached five standard deviations — something which should only occur once every 7,000 years.
Now, who wants to bet that algorithmic trading models, or banks’ risk management ones, don’t extend to this kind of (rare-ish) movement? After all, these models tend to be based on recent history and banks rarely feel the need to take into account extreme events which have never happened. Such was most famously the case, of course, in credit risk management ahead of the subprime crisis.
It’s certainly the thinking behind graphics like the below — from Reuters on Thursday:
That’s Value-at-Risk (VaR) for major US banks. In words it would mean, for example, that there’s a one in 20 chance that Goldman Sachs’ daily commodities trading net revenues would fall below expected daily trading net revenues by an amount at least as large as the reported VaR — or about $37m in the first quarter. Note that VaR predictions, however, tend to be a poor predictor of actual losses. And banks have the ability to ignore them somewhat, as Goldman Sachs did during the subprime crisis.
Here’s Kenneth Posner in his book, Stalking the Black Swan:
The company shorted the ABX index just like the hedge fund in Chapeter 4, earning more than $1 billion in profits during 2007. During this period, senior executives were monitoring the value-at-risk … associated with the firm’s mortgage position, as well as grilling the mortgage traders on the rationale for their bets. On separate occasions, the executives forced the traders to downsize their positions, even though the trades were profitable, in order to keep the VaR in check. At other times they allowed the VaR to rise to an all-time high.
Given Goldman Sachs called for Brent to return to $105 a barrel just three weeks ago — much to the amusement of some other banks (like Barclays Capital) — we’re guessing there won’t be too much Goldman hand-wringing over size able commodities VaR. If the bank followed its own published advice, it should be well-positioned (once again).
Barclays, incidentally, is one of the few European banks that does not break out its quarterly commodities VaR.