Recently
while studying for my Life Risk Management Exam coming fall I went off syllabus
to studying market risks. I have always felt that financial models tend to have
too many subtle assumptions that should always be borne in mind while working
with them and the no-arbitrage principle tops that list.
The
section on “Characteristics of financial time series” in the “Financial Enterprise Risk Management” Book (Chapter 14) had some interesting information
that I felt would serve as rule of thumb in financial modeling. My regular
perceptions on the subject did change dramatically.
Firstly;
“In
spite of the assumptions in many models to the contrary, market returns are
rarely independent and identically distributed.”
I
have always felt the same as markets tend to be driven by common perceptions
and copy cats a lot. Also there are many instances where markets go over kill with
an idea and then subsequent corrections start to take place gradually. Also,
mean reversion is always there very much observable. So does this mean models
assuming a random walk process as in the Log-normal model is wrong?
