Simulating The Quant Bloodbath

A pair of academics at MIT have published a paper that seems to confirm the Rothman Theory of this summer’s Quant Bloodbath. The Rothman Theory held that the initial quant fund losses were triggered a large hedge fund unwinding one or more market-neutral portfolios.

Now Amir E. Khandani and Andrew W. Lo have used financial models to simulate this summer’s bloodbath, and what they found largely confirms the Rothman Theory.

Their findings suggest that the quantitative nature of the losing hedge funds was incidental, and the main driver of the losses in August 2007 was the firesale liquidation of similar portfolios that happened to be quantitatively constructed. That firesale was likely set-off by a hedge fund facing margin calls or seeking to pre-emptively reduce risk after its credit portfolio was hit by this summer’s collateral and credit crunch.

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