Naked Statistics: Stripping the Dread from the Data

by Charles Wheelan

Unfortunately, there were two huge problems with the risk profiles encapsulated by the VaR models. First, the underlying probabilities on which the models were built were based on past market movements; however, in financial markets (unlike beer tasting), the future does not necessarily look like the past. There was no intellectual justification for assuming that the market movements from 1980 to 2005 were the best predictor of market movements after 2005. In some ways, this failure of imagination resembles the military’s periodic mistaken assumption that the next war will look like the last one. In the 1990s and early 2000s, commercial banks were using lending models for home mortgages that assigned zero probability to large declines in housing prices.2