There are certain characteristics of a Michael Lewis story. He loves the individualist who finds market inefficiencies. In fact, almost all of his best books are about exploiting market inefficiencies. This could be in the mortgage market through quant traders and securitization, the technology bubble, baseball general managers who have to find players or football player who have unique skills. All these stories find a visionary who is able to see something that other could not and how these entrepreneurs try and exploit these opportunities. His latest story in last Sunday’s New York Times looks at another inefficiency, catastrophic risks. http://www.nytimes.com/2007/08/26/magazine/26neworleans-t.html?ref=magazine The article discusses tail risk and how some may try and exploit the opportunity in catastrophe bonds.
Even for those who are not directly involved in the insurance industry CAT bonds, this is an interesting story. It provides some thoughtful insights on what it means to be diversified and what are the types of harm that investors may face when risks become correlated or not fully priced.
The current credit risk problem is another example of a tail risk that was not fully examined. The credit markets became correlated and there was a limited amount of diversification. The full extent of the price impact was not properly examined. Perhaps we need to brush up our knowledge of tail risks. This is not a theoretical exercise but a real world problem.
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