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It's The Leverage, Stupid

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Executive Summary

The fundamental conceit of efficient-market theory - that markets can perfectly assess and thus price, slice, and dice risk - has collapsed. Because efficient-market theory predicted very low levels of risk, most models used by quantitative analysts justified extremely high leverage - leverage that, in the end, has jeopardized our entire global financial framework. Before we can reform the global financial system, we must first understand the chief lesson from this crisis: we are fundamentally unable to properly assess financial market risk, much less optimally hedge against it. That runs counter to classical efficient-market-theory economics, which says that relevant risks can always be assessed and, indeed, optimally managed.

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