http://www.federalreserve.gov/boarddocs/speeches/1999/19991014.htm
Gig's up?
> Indeed, all value added from new financial instruments derives from the
> service of reallocating risk in a manner that makes risk more tolerable.
> Insurance, of course, is the purest form of this service. All the new
> financial products that have been created in recent years, financial
> derivatives being in the forefront, contribute economic value by
> unbundling risks and reallocating them in a highly calibrated manner. The
> rising share of finance in the business output of the United States and other
> countries is a measure of the economic value added from its ability to
> enhance the process of wealth creation.
>
[...]
> As I have indicated on previous occasions, history tells us that sharp
> reversals in confidence occur abruptly, most often with little advance
> notice. These reversals can be self-reinforcing processes that can
> compress sizable adjustments into a very short period. Panic reactions in
> the market are characterized by dramatic shifts in behavior that are
> intended to minimize short-term losses. Claims on far-distant future values
> are discounted to insignificance. What is so intriguing, as I noted earlier,
> is that this type of behavior has characterized human interaction with little
> appreciable change over the generations. Whether Dutch tulip bulbs or
> Russian equities, the market price patterns remain much the same.
>
[...]
> Probability distributions estimated largely, or exclusively, over cycles that
> do not include periods of panic will underestimate the likelihood of
> extreme price movements because they fail to capture a secondary peak at
> the extreme negative tail that reflects the probability of occurrence of a
> panic. Furthermore, joint distributions estimated over periods that do not
> include panics will underestimate correlations between asset returns
> during panics. Under these circumstances, fear and disengagement on the
> part of investors holding net long positions often lead to simultaneous
> declines in the values of private obligations, as investors no longer
> realistically differentiate among degrees of risk and liquidity, and to
> increases in the values of riskless government securities. Consequently,
> the benefits of portfolio diversification will tend to be overestimated when
> the rare panic periods are not taken into account.
>
Enrique