Lecturing birds on flying can mathematical theories destroy the financial markets

Table of Contents Title Page Copyright Page Dedication Epigraph Foreword I II III IV V VI VII Preface Mathew Gladstein’s Complaisance Essentials Chapter - Playing God Chapter - The Financial Economics Fiefdom Chapter - Quant Invasion Critique Chapter - Copulated Nightmares Chapter - Blah VaR Blah Chapter - Blue Is Not Green Chapter - The Black-Scholes Conundrum Conclusions Chapter - Black Swan Deceit? Chapter - An Unhealthy Yearning for Precision Chapter 10 - We Need Fat Tony Finale Notes Acknowledgements About the Author Index Copyright © 2009 by Pablo Triana All rights reserved Foreword © Nassim Nicholas Taleb 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, 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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 Library of Congress Cataloging-in-Publication Data: Triana, Pablo Lecturing birds on flying : can mathematical theories destroy the financial markets? / Pablo Triana p cm Includes bibliographical references and index eISBN : 978-0-470-50105-4 Finance Economics I Title HG101.T75 2009 932-dc22 2009001895 To my parents, who gave me the perfect life Too large a proportion of mathematical economics are a mere concoction, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols —John Maynard Keynes, 1936 Because of the success of science there is a kind of pseudo-science, social science is an example, which is not a science They follow the forms, they gather data and so forth, but they don’t get any laws, they haven’t found anything, they haven’t got anywhere (yet) Maybe I am wrong, maybe they know but I don’t think so, I have the advantage of having found out how hard it is to really get to know something, how careful you have to be about checking the experiments, how easy it is to make mistakes I know what it means to know something and therefore I see how they get their information and I can’t believe that they have done the works necessary, and the checks necessary, and the care necessary I have a great suspicion, that they don’t know and that they are intimidating people I don’t know the world very well, but that’s what I think —Richard Feynman, 1981 Beware of geeks bearing formulas —Warren Buffett, 2008 Chief Modeling Officer, creation of position Chriss, Neil Churchill, Winston Citigroup Clearing Corporation, of CME Collateralized debt obligations (CDO) subprime tranches Competitive advantage Complexity disguise Computer programming, quant finance and Computer revolution IBM and quant finance and Correlation crisis Correlation smile curve Cox, Jennings Credit crisis of 2007 aspects of Black Swans and financial risk and Gaussian Copula model and Lehman Brothers and mathematics and as perfect storm rating agencies and reasons for value at risk and Credit models Credit ratings, as flawed methodology Credit Suisse VaR exceptions of Currency markets D Daiquiri cocktail analogy Das, Satyajit Decision making factors affecting mathematics and statistics and de la Vega, Joseph Delta hedging Delta ratio hedge Derivatives Black-Scholes-Merton formula and Black Swans and as a business exotic forecasting and public relations and revolution value Derman, Emanuel DE Shaw Dewing, Arthur Stone Diller, Stanley Distance to default Donaldson, Lufkin & Jenrette (DLJ) Dow Jones setback (1986) Duffie, Darrell Durand, David Dynamic hedging of barrier options as cause of Black Monday normality assumption and Platonicity and of reverse knock-outs theory of E Econometrics, economics versus Economics econometrics versus Nobel Prize in Economist Economists, “physics envy” and Efficient markets Einhorn, David Einstein, Albert Engle, Robert Enron bankruptcy (2001) Equity mezz versus slice Europe, UBS in European Exchange Rate Mechanism Euthyphro (Plato) Exotic derivatives Extremistan F Fannie Mae Fat Tony example (Taleb) Federal Reserve Federer asset price Filer, Herbert Finance necessity of theorems in quantification of quantitative quantitative tools and Finance departments, in business schools Finance theory Black-Scholes-Merton formula and Black Swans and dangers of frailty models and modern Nobel Prize and normality assumption and opinions on personal goals and placidity and reinforcement of value at risk and Financial economics Black, Fischer and business finance to Financial institutions, creation of Chief Modeling Officer position in Financial models, drawbacks of The Financial Policy of Corporations (Dewing) Financial theory philosophical backbone of ruled by Normality Fixed exchange rates, Bretton Woods system Fixed-income securities Ford Foundation Forecasting derivatives errors in volatility Foreign exchange markets Formalism Formulas Black-Scholes-Merton formula as pricing option pricing Frailty factor Frailty model Frailty models finance theory and risk management and Freddie Mac Friedman, Milton Funds hedge quant G Galbraith, John Kenneth Gann, W D GARCH models Garten, Jeffrey Gaussian Copula model credit crisis and normality assumption and One-Factor Geometric Brownian Motion Girsanov theorem Gladstein, Mathew Goldman paper Goldman Sachs Goldstein, Ramy Gordon-Howell report Government securities Grants, for business schools Great Depression See Market crash Greenspan, Alan H Haug, Espen Hedge funds Black Swans and value at risk and Hedging Black-Scholes and dynamic Heritage Foundation Hibon, Michelle Highbridge Capital Management High-yielding loans Historical data predicting market movements with value at risk and Historical value, for value at risk Horn, Roy Hughes, Ian Hybrid portfolio management I Iatrogenic risk IBM volatility of Illiquid securities Implied correlation decline in Implied volatility Incremental Risk Charge International Monetary Fund (IMF) Internet bubble (2000) Investment in equity tranche model-driven strategy for quant quant fund managers and Investment banking crisis Investment banks in Europe VaR exceptions iPhone, release of iTraxx J Jarrow, Robert Jensen, Michael Job opportunities, business schools and Jonas, Stan Jorion, Philippe JPMorgan Junk mortgages, defaults on K Kassouf, Sheen Kerviel, Jérôme Kerviel risk Keynesianism Knock-out options necessity of Koren, Yaron Krugman, Paul L Latin American banking crisis Leeson, Nick Leeson risk Lehman Brothers bankruptcy of credit crisis and Lehman Stories Leibowitz, Martin Leland, Hayne Lending practices, mortgage Leverage Levitt, Steven Levy distribution Lewis, Michael Li, David Liquidations, VaR-dictated Lo, Andrew Loans high-yielding NINJA student Long Term Capital Management (LTCM) Black Swans and complexity disguise and fall of Nobel Prize and normality assumption and volatility of M Makridakis, Spyros Malabre, Alfred Market crash of 1929 of 1987 (See also Black Monday (October 1987)) Nasdaq (2000) normal distribution and possibility of Market default correlation Markowitz, Harry Marx, Karl Masters in Finance program Mathematical modeling Mathematical prodigies, market and Mathematics Black-Scholes pricing option and in business schools credit crisis and in decision making McKinsey McLeod, Alistair M3-Competition M-Competition (1982) Mediocristan Merrill Lynch risk management and value at risk and Merton, Robert MGM Mirage Siegfried and Roy show and Miller, Merton Miller-Modigliani theory Modeling default correlation errors in mathematical quant fund managers and Modern Portfolio Theory Modigliani, Aldo Monte Carlo simulation Morgan Stanley Morrice, Brad Mortgage bail outs Mortgages defaulting on junk lending practices subprime crisis and N Nasdaq crash (2000) Nelson, S.A Newton, Isaac New York Stock Exchange Niederhoffer, Victor Nietzsche, Friedrich Nikkei NINJA loans Nobel, Alfred Nobel, Peter Nobel Prize Black Monday and Black-Scholes option pricing formula and business schools and eliminating in economics finance theory and Long Term Capital Management and Sweden’s Central Bank and Normal distribution Normality assumption criticism of dynamic hedging and financial theory ruled by Gaussian Copula and Long Term Capital Management and trading and value at risk and O Obama, Barack O’Brian, John Ohio State Fisher School Business Olin Business School One-Factor Gaussian Copula Option industry, birth of modern Option pricing before Black-Scholes-Merton formula formulas supply and demand and Options Clearing Corporation (OCC) Option traders Option trading, history of Ormerod, Paul Outliers P Payne, Andy Perfect storm, credit crisis as Performativity, of theory Pierson report Platonicism Platonicity dynamic hedging and Portfolio insurance Black-Scholes model and fathers of Portfolio management, hybrid Precision, yearning for Pricing of digital and barrier options option (See Option pricing) Pricing formula, Black-Scholes-Merton formula as Pricing options Black-Scholes formula and Black-Scholes-Merton formula and Prohibition (1920s) Pure research Q Quant crisis Quant finance automation and computer programming and computer revolution and credit models and Derman, Emanuel and graduate programs in models, importance of revenue and role of models in academia versus trading floors Quant fund managers academic theorists versus Chriss, Neil educational background of Fat Tony example and investment and modeling and professional activities of Quant funds activities of crisis definition of future of key to performance of Quantification, of finance Quantitative finance adherence to defeat for volatility index Quantitative risk management limitations of pure versus applied science and Quant screens Quant trading R Ramirez, Alberto Ratings agencies, credit crisis and Ratings crisis Ratings shopping Rebonato, Ricardo Regulation, value at risk and Renaissance Technologies Research academic tenure and applied versus pure Residential Mortgage Backed Securities (RMBS) Reverse knock-outs dynamic hedging of Risk measurement of value at risk and Risk management frailty models and limitations of quantitative financial Merrill Lynch and option traders and Rosenfeld, Eric Rubin, Robert Rubinstein, Mark Ruble (Russian), devaluation of Russia, ruble devaluation in Russian default-LTCM crisis S Safe haven effect Salomon Brothers Scholes, Myron Scientific research, academic tenure and See also Research SEC See U.S Securities and Exchange Commission (SEC) Securities, government Seo, John September 11, 2001 terrorist attacks, effects of Sharpe, William Shaw, David Shreve, Steven Simon, Herbert Simons, Jim Sloan School of Business SocGen Soros, George S&P 500 Sprenkle, Case Standard deviation Standard & Poor See S&P 500 Static delta hedging Statistics, in decision making Stern School of Business Structured investment vehicles Student loans Subprime crisis Subprime lending Subway reform, Vickrey, William and Supply and demand option prices and Sveriges RiksBank See Sweden’s Central Bank Sweden’s Central Bank criticism of Nobel Prize and T Tail events Taleb, Nassim Nicholas Fat Tony character Tenure, academic Theorems Girsanov necessity of, in finance Theory dynamic hedging finance (See Finance theory) performativity of Traders Black-Scholes-Merton formula and Black-Scholes option pricing formula and option Trading of barrier options Black-Scholes-inspired normal strategy quant Trading floors models in quant finance and Treynor, Jack Trump, Donald U UBS in Europe U.S Securities and Exchange Commission (SEC) U.S Treasury Bills V Value at risk (VaR) Bear Stearns and call for support for credit crisis and defined destabilizing powers of exceptions failures of Fat Tony example and as flawed methodology flaws in historical data and Long Term Capital Management and low versus high market troubles and mathematics of Merrill Lynch and normality assumption and as regulatory requirement role as capital charge setter role of underestimated figures and weighted Value derivatives Vanguard Group Vickrey, William Viniar, David VIX See Volatility index (VIX) VIX-speak Volatility currency pairs suffering European equity index forecast implied of Long Term Capital Management Volatility fudging Volatility index (VIX) calculation as fear gauge Volatility smile birth of before and after Black Monday Black-Scholes option pricing formula and negation of Black-Scholes formula by Volatility surface Vulgarity W Weighted VaR Wilmott, Paul World Bank WorldCom bankruptcy (2002) World Economic Outlook (IMF) World War II Z Zach, Tzachi, termination of ... whether, in light of all the wreckage that unsound financial theory can cause, the Nobel Prize in Economics (with the golden reputation that it endows on the theorists and their pontifications)... www.wiley.com Library of Congress Cataloging-in-Publication Data: Triana, Pablo Lecturing birds on flying : can mathematical theories destroy the financial markets? / Pablo Triana p cm Includes bibliographical... actions by otherwise no-nonsense pros go a long way towards helping cement in the public’s psyche the notion that markets are amenable to quantification, that they can be modeled, that there can