Inside the Black Box: The Simple Truth About Quantitative Trading

10.3. EXOGENOUS SHOCK RISK

The third in the family of quant-specific risks comes from exogenous shocks. I refer to them as exogenous because they are typically driven by information that is not internal to the market. Terrorist attacks, the beginning of a new war, and regulatory intervention are all examples of exogenous shocks. Because quant models utilize market data to generate their forecasts, when nonmarket information begins to drive prices, quant strategies typically suffer. This is especially true because such shocks usually also result in larger-than-normal moves. So, in situations of exogenous shock, we have big moves that aren't explainable by a reasonable model using market data but rather by information that is entirely external to the markets (see Exhibit 10.5).

The first circled period in the S&P 500 chart in Exhibit 10.5 represents the terrorist attacks on New York and Washington, D.C., on September 11, 2001. The market was closed for almost a week, and when it reopened, it dropped precipitously, only to recover much of that ground rather quickly. Ignoring the obviously horrible nature of the attack on civilians, the downward move in markets was actually a continuation of the downward trend in stocks that had begun in March 2000 and therefore benefited trend-following strategies. However, many mean reversion strategies and relative-alpha strategies suffered in September 2001 as nonmarket information dramatically and briefly changed the way markets behaved.

Exhibit ...