**QUESTION:** Mr. Armstrong; Did AIG use the Black-Scholes Model and that is what created the crisis again in 2007?

WJ

**ANSWER:** No. It’s my understanding that AIG developed different models, they called a** “Value-at-Risk Model,” (VaR)** which used a binomial-expansion-technique to start valuing their positions. I believe the original model was developed at Moody’s. However, like the **Black-Scholes Model**, it too lacked depth. In model development, it is extremely complex.

Virtually every model created tends to be predominately flat with a minimum of dynamic variables lacking understanding of **TIME**. Then the testing period lacks the database reflecting all conditions. In the case of Black-Scholes, they back-tested only with data to 1971. If I created a model with only data from 2009 forward, then it would be biased to presume a bull market is normal in the stock market.

The Value at risk (VaR) model is a measure of the risk of investments. It **estimates** how much a set of investments might lose, given **normal market conditions**, in a set time period such as a day. VaR is typically used by firms and regulators in the financial industry to gauge the number of assets needed to cover possible losses. It obviously failed in 2007-2009 because once again it was not a **“normal market condition”** for it fails utterly to understand **CONTAGION** when sound assets are sold to raise cash for other assets that collapse. The assumption of the model is its own nemesis.

For example, if a portfolio of stocks has a one-day 5% VaR of $10 million, this actually means that there is a 5% probability that the portfolio will fall in value by more than $1o million over a one-day period if there is no trading. Therefore, a loss of $1o million or more on this portfolio would be expected on 1 day out of 20 days given a 5% probability. A loss which exceeds the VaR threshold is termed a “**VaR breach**“.

So you can see, such models are incapable of determining **TIME** and as a result, they will always fail during a **CONTAGION** that they cannot see coming.

This is why the bulk of portfolio models fails during a financial crisis. This is also why some of the top Institutional portfolios come to our firm because they have realized that only **TIME** determines the success of any model and making broad assumptions of probability have **ALWAYS** failed. If you cannot model **TIME** and** CONTAGION**, you will be wiped out during a crisis and VaR will fail just as Black-Sholes.