ffirs.indd ii 8/16/11 8:45:13 AM Red-Blooded Risk ffirs.indd i 8/16/11 8:45:12 AM ffirs.indd ii 8/16/11 8:45:13 AM Red-Blooded Risk T H E S E C R E T H IS T O RY O F WA L L S T R E E T Aaron Brown John Wiley & Sons, Inc ffirs.indd iii 8/16/11 8:45:13 AM Copyright © 2012 by Aaron Brown All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com ISBN 978-1-118-04386-8 (cloth); 978-1-118-14015-4 (ebk); 978-1-118-14017-8 (ebk); 978-1-118-14016-1 (ebk) Printed in the United States of America 10 ffirs.indd iv 8/16/11 8:45:13 AM Contents Acknowledgments xi Chapter 1 What This Book Is and Why You Should Read It Risk, Danger, and Opportunity Red-Blooded Risk Management Risk and Life Play and Money Frequentism 11 Rationality 13 Bets 15 Exponentials and Culture 18 Payoff 20 Chapter Red Blood and Blue Blood 23 Chapter Pascal’s Wager and the Seven Principles of Risk Management 29 Principle I: Risk Duality 32 Principle II: Valuable Boundary 33 Principle III: Risk Ignition 35 Principle IV: Money 38 Outside the VaR Boundary 40 Principle V: Evolution 45 Principle VI: Superposition 48 Principle VII: Game Theory 49 v ftoc.indd v 8/16/11 8:45:57 AM vi Contents Chapter Chapter Chapter ftoc.indd vi The Secret History of Wall Street: 1654–1982 57 Pascal and Fermat 58 Poker 61 Advantage Gamblers 62 Sports Betting 63 Quants to Wall Street 66 Finance People 68 Real Finance 69 When Harry Met Kelly 73 Kelly 74 Harry 76 Commodity Futures 79 If Harry Knew Kelly 84 Investment Growth Theory 88 eRaider.com 92 MPT Out in the World 96 Exponentials, Vampires, Zombies, and Tulips 101 Types of Growth 102 The Negative Side 105 Tulips 106 Tulip Propaganda 108 Quantitative Tulip Modeling 111 Money 112 Chapter Money 117 Chapter The Story of Money: The Past 125 Property, Exchange, and Money 126 Paleonomics 128 Transition 131 What Money Does 134 Risk 135 Government and Paper 138 Paper versus Metal 142 1776 and All That 145 8/16/11 8:45:58 AM Contents Chapter Andrew Dexter 147 A Short Digression into Politics and Religion 150 The Secret History of Wall Street: 1983–1987 155 Efficient Markets 157 Anomalies 159 The Price Is Right Not! 161 Efficiency versus Equilibrium 162 Beating the Market 165 Paths 170 Sharpe Ratios and Wealth 174 1987 177 Chapter 10 The Story of Money: The Future Farmers and Millers ftoc.indd vii vii 179 180 Money, New and Improved 183 A General Theory of Money 185 Value and Money 189 Numeraire 191 Clearinghouses 196 Cash 197 Derivative Money 200 The End of Paper 203 Chapter 11 Cold Blood 207 Chapter 12 What Does a Risk Manager Do?—Inside VaR 213 Professional Standards 213 Front Office 215 Trading Risk 217 Quants on the Job 218 Middle Office 222 Back Office 225 Middle Office Again 227 Looking Backward 228 Risk Control 230 Beyond Profit and Loss 232 8/16/11 8:45:58 AM viii Contents Numbers The Banks of the Charles 236 Waste 238 The Banks of the Potomac 241 The Summer of My Discontent 245 Validation 247 Chapter 13 VaR of the Jungle 251 Chapter 14 The Secret History of Wall Street: 1988–1992 255 Smile 256 Back to the Dissertation 258 Three Paths 262 An Unexpected Twist 265 Surprise! 267 Computing VaR 271 Chapter 15 Hot Blood and Thin Blood 277 Chapter 16 What Does a Risk Manager Do?—Outside VaR 283 Stress Tests 283 Trans-VaR Scenarios 287 Black Holes 289 Why Risk Managers Failed to Prevent the Financial Crisis 290 Managing Risk 296 Unspeakable Truth Number One: Risk Managers Should Make Sure Firms Fail 299 Unspeakable Truth Number Two: There’s Good Stuff beyond the VaR Limit 305 Unspeakable Truth Number Three: Risk Managers Create Risk 309 Chapter 17 The Story of Risk 313 Chapter 18 Frequency versus Degree of Belief 323 Statistical Games ftoc.indd viii 234 324 Thorp, Black, Scholes, and Merton 329 Change of Numeraire 333 Polling 336 The Quant Revolution 341 8/16/11 8:45:58 AM About the Author Aaron Brown is risk manager at AQR Capital Management in Greenwich, Connecticut His previous books are The Poker Face of Wall Street (John Wiley & Sons, 2006, selected one of the 10 best books of 2006 by BusinessWeek) and A World of Chance (with Reuven and Gabrielle Brenner, Cambridge University Press, 2008) In his 30-year Wall Street career, he has been a trader, portfolio manager, head of mortgage securities, and risk manager for institutions including Citigroup and Morgan Stanley He also served a stint as a finance professor, and was among the top poker players in the world during the 1970s and 1980s He is a regular columnist for two financial journals: Wilmott and Quantum and contributes frequently to the professional literature in journals, periodicals, and book chapters He holds degrees in Applied Mathematics from Harvard and Finance and Statistics from the University of Chicago Booth School of Business He lives on the Upper West Side of Manhattan with his wife, Deborah Pastor, and has two children, Aviva who goes to high school and Jacob who is an undergraduate at the University of Chicago 401 babout.indd 401 8/16/11 8:29:40 AM both04.indd 404 8/16/11 8:33:40 AM About the Illustrator Eric Kim began his career in comics with the series Love as a Foreign Language, published by Oni Press He has also illustrated Degrassi: The Next Generation Vol 3, created the comic strip series Battle Academy, The Sidesteppers (which appeared in Owl magazine), Streta, and The Complete Plays of William Shakespeare His next comics project will be coming out through Oni Press “It’s been a real privilege to work with Aaron Brown on this project Comics has always been my passion, and utilizing the medium to help explain economic concepts is a contribution that I’m happy to make I hope readers enjoy the works presented here, and hope we get a chance to collaborate again!” 403 both04.indd 403 8/16/11 8:33:40 AM babout.indd 402 8/16/11 8:29:41 AM Index Accuracy ratio, 221 Adams, Brandon, 395 Aggregation process, 297 Ainsley, Craig, 258–259, 261 Algorithmic Trading and DMA ( Johnson), 396 Algren, Nelson, 395 All the Devils Are Here (McLean and Nocera), 399 Allen, Franklin, 396 Anderson, Chris, 399 Anomalies, 159–160 Anthropology of Economy, The (Gudeman), 394 Arbitrage, 164–167, 171, 258, 260, 262, 330 Ariely, Dan, 398 Ars Conjectandi (Bernoulli), 325, 327 Augar, Philip, 395 Autocorrelation, 260 Basel capital rules, 225, 228, 352–353, 354, 356–357, 358–359 Bayes, Thomas, 327 Bayesians/Bayesian concepts See also Probability betting/probability and, 10, 18, 328 foundation of, 59–60, 65 frequentism and, 12, 327 in history/law, 58 “prior beliefs” and, 261, 262 risk defining capital, 350 technology startups and, 367–368 Beat the Dealer (Thorp), 67 Beat the Market (Thorp and Kassouf), 67 Behavioral Game Theory (Camerer), 398 Bennet, Rick, 395 Bernoulli, Jakob, 325–327, 336, 343 Berns, Gregory, 398 Bernstein, Peter, 395 Betting: Kelly bets, 262, 342 probability and, 10, 15–18, 328 public, 337 sports, 63–66, 349, 367 Beyond Counting (Grosjean), 395 Beyond Individual Choice (Bacharach), 398 Big Short, The (Lewis), 399 Black, Alethea, 396 Bacharach, Michael, 398 Back office, 225–227 Backward-looking risk management, 228–230 Bad-boy publicity, 347–348 Bad Bet (O’Brien), 395 Bankers Trust, 225, 266 Bank for International Settlements, 352 Bank One, 291 Barter, Exchange and Value (Humphrey and Hugh-Jones), 394 405 bindex.indd 405 8/16/11 8:55:31 AM 406 Index Black, Fischer, 51, 60, 238, 255–256, 329, 395–396 Black-Scholes-Merton model, 329, 331–332 Black Swan, The (Taleb), 32, 393 Black Wednesday, 52 Bloom, Murray Teigh, 95 Bogle, John, 297 Bond ratings, 263, 293–294 Bookstaber, Richard, 393 Born Losers (Sandage), 395 Bounds of Reason, The (Gintis), 398 Brenner, Reuven and Gabrielle, 395 Bringing Down the House (Mezrich), 63 British Treasury, 52–53 Broke, (Adams) 395 Bronze Age, 136, 137 Bronze Age Economics (Earle), 394 Bubble investors, 106, 111, 112, 116, 191 Bulls, Bears, and Brains (Leitzes), 399 Burton, Robert Alan, 398 Business Cycles and Equilibrium (Black), 396 Busting Vegas (Mezrich), 63 Calvet, Laurent E., 396 Camerer, Colin 398 Capital: allocation, 359–362 at-risk, 266 formation, 359–360 requirement, 350–352 Capital asset pricing model (CAPM), 88–92, 96–97 Capital Ideas (Bernstein), 395 Capital Offense (Hirsh), 399 Carnap, Rudolph, 59 Cash, Lehman Brothers and, 197–198 Cash Nexus (Ferguson), 394 bindex.indd 406 Chance, Luck, and Statistics (Levinson), 394 Chances Are (Kaplan), 394 Change of numeraire, 42–43, 333–336 Checklist Manifesto, The (Gawande), 398 Chernow, Ron, 395 Chicago Board Options Exchange Volatility Index (VIX), 229 Chief risk officer (CRO), 215 Chiles, James, 398 Cincinnati Kid, The ( Jessup), 395 Citibank, 225, 266 Clearinghouses, 196–197 CMOs See Collateralized mortgage obligations (CMOs) Cohen, Muhammad, 399 Cohen, William, 399 Coherent Stress Testing (Rebonato), 397 Collateralized mortgage obligations (CMOs), 257–258 Commodity futures, 79–84 Company of Strangers, The (Seabright), 394 Complete TurtleTrader, The (Covel), 297 Connor, Gregory, 397 Conquering Risk (Feustel), 395 Controllers/comptrollers, 224 Covel, Michael, 397 Cowboys Full (McManus), 395 Cox, Richard, 327 Cramer, Jim, 348 Credit derivatives, 362 Credit stress test, 285, 292 CRO See Chief risk officer (CRO) Danger, opportunity and, 2–4 Death of the Banker, The (Chernow), 395 Debt monetization, 349 Declining marginal utility, 41 8/16/11 8:55:31 AM Index de Condorcet (Marquis), 59 de Finetti, Bruno, 10, 327, 328, 394 Degree of belief See Bayesians/ Bayesian concepts; Frequency vs degree of belief Demon of Our Own Design, A, (Bookstaber), 393 Derivatives/derivative money: capital creation and, 349 clearinghouses, 186, 192, 196–197 definition, 331 derivative money, 186, 188–196, 200–203 energy sector and, 184 –185 exposure from derivatives, 266 liquidity and, 191 as the new money, 185–189 numeraire and, 191–196 spread trade and, 183 as store of value, 187 Derivatives Models on Models (Haug), 396 Derman, Emanuel, 396 Desrosières, Alain, 397 Dexter, Andrew, 147–149 Diogenes, 247 Disintermediation, 361 Dissertation (Brown), 258–262 Dorner, Dietrich, 243, 398 Drobny, Steven, 397 Druckenmiller, Stanley, 52 Duffie, Darrell, 399 Earle, Timothy, 394 Economic Function of Futures Markets, The (Williams), 397 Economics of Risk and Time, The (Gollier), 397 Econophysics, 46 Education of a Speculator, The (Niederhoffer), 297 Efficient markets hypothesis (EMH), 86–88 bindex.indd 407 407 Efficient markets theory: empirical evidence, 158–159 equilibrium price and, 162–165 father of efficient markets, 162 generally, 157–159 market inefficiencies and, 162 misrepresentations and, 161 myth about, 157–158, 160 Efron, Brad, 51, 394 Eichengreen, Barry, 395 Einhorn, David, 397 Eisenhower, Dwight, 53 Emergence of Probability, The (Hacking), 394 EMH See Efficient markets hypothesis (EMH) Energy industry, 168–169, 184–185 Engle, Rob, 259, 261 Equilibrium, 88, 162–165 eRaider.com, 92–96, 239 Errors/error rates, 234–236 ETFs See Exchange-traded funds (ETFs) Evans, Dylan, 218, 393 Evolution, 45–48, 128 EWMA See Exponentially weighted moving average (EWMA) Exchange, 126–128, 129–130, 131, 154 Exchange Artist, The (Kamensky), 395 Exchange-traded funds (ETFs), 172 Exorbitant Privilege (Eichengreen), 395 Expected Returns (Ilmanen), 396 Expected value, 41 Exploratory Data Analysis (Tukey), 394 Exploring General Equilibrium (Black), 395 Exponentially weighted moving average (EWMA), 273 8/16/11 8:55:32 AM 408 Index Exponentials See also Tulips/ tulipomania AIDS and, 104–105 culture and, 18–20 growth and, 102–105 negative, 105–106 risk and, 101–102 Extraordinary Popular Delusions and the Madness of Crowds (Mackay), 106–107 Faith, Curtis, 297 Falkenstein, Eric, 396 Fama, Eugene, 162 Fannie May (Federal National Mortgage Agency), 292 Fat tails, 260–261 FCM See Futures commission merchant (FCM) Federal Reserve, 53, 197 Ferguson, Niall, 394 Fermat, Pierre, 29, 58–61, 61–62, 323–324, 325, 330, 343 Feustel, Elihu, 395 Financial activity, social value of, 156–157 Financial crisis: failure to prevent, 290–296 leverage limits and, 353 main reason for, 348 market-to-market accounting and, 350 risk takers and, 364–365 Financial markets, functions of: capital allocation, 359–362 capital formation, 359–360 price discovery, 362–364 Financial scandals, 346–347, 359–360 Financing the Future (Allen and Yago), 396 Finding Alpha (Falkenstein), 396 Fischer Black and the Revolutionary Idea of Finance (Mehrling), 395 bindex.indd 408 Flaw of Averages, The (Savage, Sam), 394 Fool’s Gold (Tett), 399 Fooled by Randomness (Taleb), 32, 393 Fooling Some of the People All of the Time (Einhorn), 297 Foreign exchange (FX), 257, 266 “Fortune’s formula,” 19 Fortune’s Formula (Poundstone), 393–394 Foundations of Statistics, The (Savage, Jimmy), 394 Founding Fathers, 147 Fox, Justin, 395 Freddie Mac/FHLMC (Federal Home Loan Mortgage Corporation), 292 Free (Anderson), 399 French, Kenneth, 398 Frequency vs degree of belief: Bayesians and, 327–328 beliefs vs preferences, 323, 325 change of numeraire, 333–336 Fermat and Pascal, 323–324 hypothetical random processes, 325–327 moneylike nature, 328–329 political polling, 336–341 quant revolution, 341–343 statistical games, 324–329 Thorp, Black, Scholes, Merton, 329–332 Frequentism: dual-class share arbitrage, 164–165, 166–168 frequentists vs Bayesians, 11–13 Friedman, Milton, 76 Front-office risk manager, 215–217, 220–221 8/16/11 8:55:32 AM Index Fudenberg, Drew, 398 Futures commission merchant (FCM), 196 Futures contracts, 179–183, 195 FX See Foreign exchange (FX) Galbraith, John Kenneth, 359 Gambling, 8, 9, 14, 17, 58, 62–63, 130 Gambling and Speculation (Brenner and Brown), 395 Game theory: causality and, 51 data collection, 49–50 decision maker identity, 54 human psychology, 54–55 practical example, 50 “Prisoner’s Dilemma”, 53, 55 randomness and, 51–52 risk management and, 49–55 story of money and, 126, 128 GARCH See Generalized autoregressive conditional heteroskedasticity (GARCH) Gasoline: crack spread, 168–169 rationing project, 241–245 Gawande, Atul, 398 Generalized autoregressive conditional heteroskedasticity (GARCH), 259, 261 Ginnie Mae See Government National Mortgage Association (GNMA) Gintis, Herbert, 398 Glass-Steagall, 345 Gold and silver, 79–81, 83, 112, 113, 115, 132, 133, 137–145, 149, 185, 187, 189–192, 203, 348, 351, 359 Goldberg, Lisa, 397 Goldstein, Phil, 95 Gollier, Christian, 397 bindex.indd 409 409 Government: bailout, 292 paper money and, 138–143 politics and, 151–152 religion and, 154 Government National Mortgage Association (GNMA), 170–172 Great Depression, 293, 294 Great Transformation, The (Polanyi), 394 Greed Merchants, The (Augar), 395 Gregory, C A., 394 Griffin, Peter, 395 Grosjean, James, 395 Growth, types of, 102–105 Gudeman, Stephen, 394 Hacking, Ian, 394 Handbook of Portfolio Mathematics, The (Vince), 396 Happiness (McMahon), 398 Haug, Espen, 396 Hayek, F A., 50 Hedge funds, 78, 83, 96, 97, 99, 266, 367 Herbert, Zbigniew, 108, 109, 399 Heteroskedasticity, 259–261 Hirsh, Michael, 399 Historical simulation VaR, 271–273, 274–275 History of Statistics, The (Stigler), 394 Hoffer, Richard, 395 Hong Kong on Air (Cohen, Muhammad), 399 House of Cards (Cohan, William), 399 How Big Banks Fail and What to Do about It (Duffie), 399 Hugh-Jones, Stephen, 394 Humphrey, Caroline, 394 Iceberg Risk (Osband), 393 IGT See Investment growth theory (IGT) 8/16/11 8:55:32 AM 410 Index Ilmanen, Antti, 396 Implied volatility, 331–332 Index funds, 158 Inflation, 115, 146, 181, 190, 247 Inside the Black Box (Narang), 396 Inside the House of Money (Drobny), 397 Internet See Bubble investors Investment growth theory (IGT): EMH and, 86–87 equations, MPT and IGT CAPM, 88–89 fairness and, 98–99 IGT CAPM and MPT CAPM, 89–92, 96 virtues of, 84–86 Inviting Disaster (Chiles), 398 Is God a Mathematician? (Livio), 394 Jackknife, the Bootstrap, and Other Resampling Plans, The (Efron), 394 Jackpot Nation (Hoffer), 395 Jessup, Richard, 395 John Bogle on Investing (Bogle), 397 Johnson, Barry, 396 Johnson, Simon, 395 JPMorgan, 224–225, 226, 266, 269, 291, 292 Junk bonds, 293 Kahneman, Daniel, 126 Kamensky, Jane, 395 Kaplan, Michael, 394 Kassouf, Sheen, 67 Kelly, John, 19, 35, 67, 73, 74–76, 80, 84–85 Kelly bets/levels of risk, 262, 296–297, 342 Kelly principles/investors, 173, 174 Keynes, John Maynard, 283, 328 bindex.indd 410 Key performance indicators (KPIs), 248–249 Key risk indicators (KRIs), 248 King of a Small World (Bennet), 395 Korajczyk, Robert, 397 Knetsch, Jack, 126 Knight, Frank, 59, 328 Kraitchik, Maurice, 333–334 Krüger, Lorenz, 60 Laplace, Pierre-Simon, 327 Lehman Brothers, 197–200, 291 Leitzes, Adam, 399 Lepercq de Neuflize, 172 Leverage, 294, 295, 353, 363 Levine, David, 398 Levinson, Horace, 394 Lewis, Michael, 399 Limits of Safety, The (Sagan), 398 Liquidity, 294, 351, 361–362, 363–364 Livio, Mario, 394 Logic of Failure, The (Dorner), 397 Long-Run Collaboration on Games with Long-Run Patient Players, A (Fudenberg and Levine), 398 Loss aversion, 126 Lowenstein, Roger, 399 Mackay, Charles, 106–107, 109, 110, 112 Madoff, Bernie, 360 Mallaby, Sebastian, 397 Man with the Golden Arm, The (Bennet), 395 Managed futures, 168 Managing risk, 296–298 Mandelbrot, Benoit, 396 Market: “beating” the, 165–169 efficiency, 156–157 (see also Efficient markets theory) 8/16/11 8:55:32 AM Index equilibrium (see Equilibrium) portfolio, 81 prices, 161–162, 168–169 return, 158–159 sympathy, 114 Mark-to-market accounting, 350, 352 Markowitz, Harry, 73, 80–81, 83–84, 85 See also Modern portfolio theory (MPT) McLean, Bethany, 399 McMahon, Darrin, 398 McManus, James, 395 Medici Money (Park), 394 Mehrling, Perry, 395 Merck, 173 Merrill Lynch, 291, 347 Merton, Robert, 255, 329 Mezrich, Ben, 63 Middle office, 222–225, 227–228, 230–232 Mihm, Stephen, 395 (Mis)behavior of Markets, The (Mandelbrot), 396 Modern portfolio theory (MPT), 76–78, 84–85, 86, 96–99 Momentum investors, 195 Momentum trading, 168 Money See also Paper money; Story of money derivative money, 189, 191–196, 200–203 functions of, 185, 187–188 general theory of, derivatives and, 185–189 issuance, competition and, 193 play and, 9–11 reasons to hold, 187 risk management and, 38–45 token and commodity, 132 tulipomania and, 111–112, 115 Moneyness, 332 Moore’s law, 105 bindex.indd 411 411 More Money Than God (Mallaby), 397 Morgan Stanley, 291 Mortgage securities, 170–171, 362 Mosteller, Frederick, 51 MPT See Modern portfolio theory (MPT) MPT CAPM, 88–92, 96–98 MSCI Barra, 270 Multifractal Volatility (Calvet), 396 My Life as a Quant (Derman), 396 Myth of the Plan, The (Rutland), 398 Myth of the Rational Market, The (Fox), 395 Narang, Rishi K., 396 NASDAQ index, 94, 305, 306 Nation of Counterfeiters, A, (Mihm) 395 New Financial Order, The (Shiller), 396 New Lombard Street, The (Mehrling), 395 Niederhoffer, Victor, 397 No Reserve: The Limit of Absolute Power (Redado), 53 Nocera, Joe, 399 Nonmoney exchange, 39 Nonparametric methods, 263, 264 Normal Accidents (Perrow), 398 Numeraire(s) See also Change of numeraire definition, 11 derivative money, 191–195 diversity of, 193–194 economic value and, 194–195 market return and, 158 money as, 187–188 O’Brien, Tim, 395 Off-balance-sheet items, 352 On Being Certain (Burton), 398 Opportunity, danger and, 2–4 Options, smile and skew, 256–257 Origins of the Crash (Lowenstein), 399 Osband, Kent, 393 8/16/11 8:55:32 AM 412 Index Pairs trading, 171 Paleonomics, 128–131 Paper money: clearing mechanisms, 185–186 end of, 203–205, 247 for loans, 140 government and, 138–143 vs precious metal, 142–145 replacement for, 179, 183 Parametric VaR, 273–274, 276 Park, Tim, 394 Pascal, Blaise: bets, dice throws and, 29, 61–62, 325, 330, 343 letters to Fermat, 323–324 Pascal’s wager, 29–32, 42–43, 47, 335 religion, risk and, 150 utility maximization and, 43 Wall Street and, 58–61 Patterson, Scott, 396 Paul Wilmott Introduces Quantitative Finance (Wilmott), 396 Performance ratio, 221 Perrow, Charles, 398 Petroski, Henry, 398 Pfizer, 173 Philosophical Lectures on Probability (de Finetti), 394 Pilkey, Orrin, 398 Play, 1, 2, 8, 9–11, 18 Plight of the Fortunetellers (Rebonato), 397 Poisson, Siméon, 59 Poker, 61–62, 246 Poker player types, 219, 220 Polanyi, Karl, 394 Politics: election polling, 336–341 religion and, 150–154 Politics of Large Numbers, The (Desrosières), 397 Porter, Theodore, 397 bindex.indd 412 Portfolio Risk Analysis (Connor, Goldberg, and Korajczyk), 397 Portfolio Selection (Markowitz), 77 Poundstone, William, 394 Predictably Irrational (Ariely), 398 Price discovery, 363 Probability See also Bayesians/ Bayesian concepts field of, 59 as long-term frequency, 326 outcomes/utility of outcomes, 60 risk-neutral distribution, 332 “rocket scientists” and, 17–18 theory, 51, 333–334 (see also Frequentism) Product placement, 110 Professional standards, 213–215 Profit and loss: distribution, holes in, 289–290 looking beyond, 232–234 Property exchange, money and, 126–128 Public betting, 337–340 Qualitative managers, 33 Quantitative modeling, 151 Quants/quantitative managers: old-school/new-school, 173–174 revolution, 341–343 stock market crashes and, 33 three camps of, 219 to Wall Street, 66–68 Quants, The (Patterson), 396 Quine, W V O., 60 Randomness/randomness theory: deliberately introducing, 326 in evolution, 35, 42, 45–47, 48, 51 game theory and, 49–50, 51, 52, 324–325 superposition and, 48 Rational Optimist, The (Ridley), 394 Rationality, 13–15 8/16/11 8:55:32 AM Index Real estate investment trust (REIT), 93 Rebonato, Riccardo, 397 Redado, Martin, 53 Refrigeration experiment, 243 REIT See Real estate investment trust (REIT) Religion, politics and, 150–154 Resampling, 260 Reserve requirements, 350–351 Retirement plans, 348 Ridley, Matt, 394 Risk: analysis, major complication in, 44 -based capital, birth of, 350 control, 224, 225, 230–232, 265 culture and, 19–20 danger, opportunity and, 2–4 duality, 32, 33, 38 ignition, 35–38, 102 levels/limits, 297, 298 life and, 7–9 management, 4–7 (see also Seven principles of risk management) neutral probability distribution, 332 optimizing, 10 property and, 127–128 story of, 315–321 story of money and, 135–138 strategy, 298 types of, 225–226 weights, 352 Risk Intelligence (Evans), 218, 393 Risk managers: back office, 225–227 backward-looking risk management, 228–230 bad numbers and, 236–238 beyond profit and loss, 232–234 creating risk, 309–312 errors/error rates and, 234–236 bindex.indd 413 413 front office, 215–217 gas rationing project, 241–245 making sure firms fail, 299–305 middle office, 222–225, 227–228 poker playing and, 245–247 professional standards, 213–215 quants on job, 218–222 risk control, 230–232 trading risk and, 217–218 validation and, 247–249 waste and, 238–241 RiskMetrics, 270, 273, 275 Risk takers: iron rules for, 7–8 vs risk avoiders, 366–368 “Rocket scientists:” probability and, 17–18 quants as, 5–6, 10, 11, 15 real finance and, 69 “risk ignition,” 102 Wall Street and, 57, 62, 66–67, 69, 71 Rogues to Riches (Bloom), 95 Rumsfeld, Donald, 59 Rutland, Peter, 398 Sagan, Scott Douglas, 398 Sahlins, Marshall, 394 Salomon Brothers, 172 Sandage, Scott, 395 Satisfaction (Berns), 398 “Satisficing,” 42 Savage Money (Gregory), 394 Savage, Jimmy, 394 Savage, Sam, 394 Scenario analysis, 287–289 Scholes, Myron, 255, 329 Seabright, Paul, 394 SEC See Securities and Exchange Commission (SEC) Secret history of Wall Street: 1654-1982 period, 57–69 1983-1987 period, 155–176 8/16/11 8:55:32 AM 414 Index Secret history of Wall Street (continued ) 1988-1992 period, 255–276 1993-2007 period, 345–368 Securities and Exchange Commission (SEC), 94, 97 Securitization, 349, 361–362 Seven principles of risk management: I: risk duality, 32–33 II: valuable boundary, 33–35 III: risk ignition, 35–38 IV: money, 38–45 V: evolution, 45–48 VI: superposition, 48–49 VII: game theory, 49–55 Sharpe ratio, 81, 83, 91, 92, 174–176 Shiller, Robert, 204, 396 Smile and skew option, 256–257 Soros, George, 52 Sports betting/bettors, 63–66, 219–220 Spread trade, 183, 293–294 Squam Lake Report, The (French, et al.), 399 Statistical arbitrage, 171 Statistical Decision Functions (Wald), 394 Statistical games, 324–329 Statistical reasoning, basic principles, 342–343 Statistics, history of, 60 Stigler, Steven, 60, 394 Still Life with a Bridle (Herbert), 399 Stock market crash: Monday, October 19, 1987, 33, 177, 255, 256, 258, 262, 264 Stoller, Martin, 239 Stoller, Phil, 95 Stone Age Economics (Sahlins), 394 Story of money: 1776, continental dollars, 145–147 bindex.indd 414 Andrew Dexter, 147–149 generally, 125–126 government and paper, 138–143 paleonomics, 128–131 paper vs metal, 142–145 property, exchange and, 126–128 risk, 135–138 transition, 131–134 what money does, 134–135 Strange Days Indeed (Wheen), 399 Stress tests, 283–287 Sull, Donald, 398 Superposition, 48–49 Tail risk—extreme events, 268 Tale of High-Flying Speculation and America’s First Banking Collapse, A (Kamensky), 395 Taleb, Nassim, 32, 37, 393 Tett, Gillian, 399 Thaler, Richard, 126 13 Bankers ( Johnson), 395 Thirty Years War, 113 Theory of Blackjack, The (Griffin), 395 Thorp, Edward, 67, 86, 255, 329 To Engineer Is Human (Petroski), 398 “Tolling” swap, 184 Trading from Your Gut (Faith), 297 Trading risk, 217–218 Transaction taxes, 146 Treasury bills/bonds, 170, 171 Trust in Numbers (Porter), 397 Tukey, John, 51, 394 Tulips/tulipomania, 106–116 Unspeakable truths: good stuff beyond VaR limit, 306–309 parametric, 273–276 risk managers create risk, 309–312 8/16/11 8:55:33 AM Index risk managers should make sure firms fail, 299–305 Upside of Turbulence, The (Sull), 398 Useless Arithmetic (Pilkey), 398 Utility theory: change of numeraire and, 42–43 decision maker identity and, 43 declining marginal utility and, 41 extensions, 41–42 utility maximization, 42 Valuable boundary, 33–35 Value at risk (VaR) See also Historical simulation VaR back-testing, 230, 233, 271, 275, 342 beyond profit and loss, 232–234 birth of, 267, 349 computing, 271–276 defined operationally, 33 illustration, 253–254 inside boundary, 270, 296 middle office, 227–228, 230, 232 not measure of risk, 269 as orthodox method, 214 outside boundary, 40–45, 270, 296, 298 parametric, 273–276 risk management and, 33–35 bindex.indd 415 415 scaling factor, 275, 276 validation and, 247–249 “VaR breaks,” 33, 268, 269 Value investors, 195 VaR See Value at risk (VaR) Vega, 332 Vince, Ralph, 396 Virtual systems, experiments and, 243–244 VIX See Chicago Board Options Exchange Volatility Index (VIX) Volatility: heteroskedasticity, 259–261 homoskedasticity, 259 implied, 331–332 local and stochastic, 257 Volcker, Paul, 368 Wald, Abraham, 394 Waste, 238–241 Wealth, Sharpe ratios and, 174–176 Weatherstone, Dennis, 269 Wheen, Francis, 399 Williams, Jeffrey, 297 Wilmott, Paul 396 Yago, Glenn, 396 8/16/11 8:55:33 AM ... 238 The Banks of the Potomac 241 The Summer of My Discontent 245 Validation 247 Chapter 13 VaR of the Jungle 251 Chapter 14 The Secret History of Wall Street: 1988–1992 255 Smile 256 Back to the. .. 19 The Secret History of Wall Street: 1993–2007 Where Did the Money Come From? ftoc.indd ix ix 345 348 Where Did They Put the Money? 359 Where Did the Money Go? 364 Chapter 20 The Secret History. .. probabilities of groups of predictions In a frequentist interpretation of a drug trial, there is no estimate of the probability that the drug works, only of the c01.indd 11 8/16/11 8:34:00 AM 12 Red- Blooded