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• Friday, August 17, 2007 04:33 PM

  Risk, uncertainty and inevitability

  As Nouriel Roubini and others have pointed out, Frank Knight wrote 85 years ago (in Risk, Uncertainty and Profit) that risk is the prospect of loss that you can measure based on experience and put a price on. Uncertainty is the prospect of loss that you can't measure. And, I would add, inevitability is what happens when those two are commingled.

  This is hardly a new observation, and as before I draw your attention to Martin Mayer's trenchant observations eight years ago, when the new dotcom economy was erasing the old economics and the most important political question was who done what to who in the Oval Office pantry. Mayer had been writing about derivatives for the better part of a decade before this 1999 interview. He stated in part,

  "I’ve worked on a fourth law, but haven’t come up with the right aphorism. That law will hold that the more abstract the instrument, the less it depends on real developments in real economies, and the more likely it is to be a vector of contagion. When you are comparing things that are extremely dissimilar, and when you have correlations without causes, you are creating the opportunity for contagion—and in a dynamic hedging environment you are indeed creating a virtual certainty of contagion."

  http://www.derivativesstrategy.com/magazine/archive/1999/0899qa.asp

  That inevitability is what we now have to worry about.

  —Fred Heutte Read Fred Heutte's other letters
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