RIP: Modern Theory of finance

This article also discusses the current financial crisis and whether risk management is to blame. The article is a defense for risk management but criticizes the modern theory of finance. The article describes certain risk management strategies, identifying risk and calculation the risk with financial models. Beta is used as the most valid calculation of risk. However, our lessons in class will tell you that there are many calculations of risk and using them together gives you the best analysis of risk. On a sample exam question Value at risk and Beta were both used to compare the risk of two companies. One company had a Beta of 1, while the other had a Beta of 2. The one with Beta=2 had VaR= $2 million and the other had VaR= $2 billion. The Betas are fairly close, and when using only Beta comparisons, the company with a beta of 2 looks more risky. However, when taking the VaR into account, you would see that the VaR of $2 billion is way more to risk than $2 million. Therefore, the company with the more stable Beta turns out to be the riskier company.

These models and their interpretations are the problems causing the crisis. The problem stated once again as we discussed in class is that not all risks follow a normal distribution. The assumption for financial theory in the ideal world models such as CAPM and Modigliani and Miller is that risks follow a normal distribution. But, analysts ignore the fail tails of the distribution. Riskier investments have fatter tails. These fat tails are times when the market is a boom or a bust, which can happen unpredictably. The main cause of the crisis is taking these models as truth and using no other analysis.

http://www.thehindubusinessline.com/manager/2009/02/02/stories/2009020250321000.htm