Professor Yuying Li warns banks and investment firms to expect the unexpected

Friday, February 15, 2013

By Beth Gallagher

Communications and Public Affairs

Photo of Yuying LiYuying Li looks deeply into the unpredictable and sometimes catastrophic events that haunt investors.

While her expertise is managing risk, the University of Waterloo computer science professor specializes in how to avoid huge losses on the stock market when random events hit unexpectedly.

“You think these things won’t happen,” says Li, a professor in the Cheriton School of Computer Science. “But they can. If you don’t consider these events, you won’t be prepared.”

From a statistical point of view these events are known as “tail events” because they happen so rarely and are represented at the tail ends of a typical bell curve.

In a normal bell curve, the most likely returns on an investment will be at the top of the bell. The most unlikely will be at the bottom, or the “tails.” Li designs computational algorithms and generates strategies that focus on tail events.

Two examples of major tail events are the 1987 market crash, and the downfall of the U.S. firm, Long-Term Capital Management (LTCM.) When LTCM’s major hedge fund collapsed in 1998, the Federal Reserve supervised a massive bailout to avert panic and even more losses on Wall Street.

While Li’s complex work is geared toward banks, insurance companies and investment institutions, she points out that ordinary people consider tail events every time they buy insurance. “You buy house insurance in the unlikely event that it will burn down,” Li says.

Tail events are getting more attention because of the 2008 financial crisis. “Both Canada and the U.S. are making an effort to manage risk better,” says Li. “It certainly is on the national agenda.”

One promising advance, she says, is the recent establishment of a Global Risk Institute, a partnership of the federal and provincial governments, the financial services industry and several universities including the University of Waterloo. Thomas Coleman, director of the Waterloo Research Institute in Insurance, Securities and Quantitative Finance (WatRISQ) serves as a research advisor for the Global Risk Institute.

While Li’s academic focus is gaining traction in the real world, she smiles when asked about the impact the global financial crisis has had on investors:  “How much one learns from these things, I don’t know.”

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