We'll explain this number, and how it could be interpreted, later. For the moment, let's just say that whatever it means in terms of risk, it seems like a dangerously big number for what is, let's be honest, just a service industry.
This book is not about the fallout from the crisis – plenty of books and column inches have been written about that – but about helping to prevent the next one (which won't look like the last one). To do that, it is necessary to go into the engine room of this massive shadow economy and understand how quantitative analysis works. How do you create a quadrillion dollars out of nothing, blow it away, and leave a hole so large that even years of the deliberately misnamed “quantitative easing” can't fill it – and then go back to doing the same thing, only faster? Part of a quant's job, as we'll see, is science, and another part (the one where mathematics is used to obfuscate reality) is the opposite of science. We will discuss both, starting with the science.
The book is divided into two main parts. The first five chapters dip into the history of quantitative finance and explain its key principles, such as risk analysis, bond pricing, portfolio insurance – all those gold-standard techniques, in short, which completely failed during the crisis, but have yet to be properly reinvented. We explore the elegant equations used in financial mathematics, and show how the deadly allure of their ice-cold beauty has misled generations of economists and investors. We trace the development of financial derivatives from bonds to credit default swaps, and show how mathematical formulas helped not just to price them, but also to greatly expand their use to the point where they dwarfed the real economy. And we show how risk-management and insurance schemes have led to more risk and less insurance than arguably at any time in history.
The second part is about the quantitative finance industry today, and how it is evolving. We will show what quants do, the techniques they use, and how they continue to put the financial system at peril. Part of the problem, we'll see, is that quants treat the economy as if it obeys mechanistic Newtonian laws, and – by nature and by training – have no feel for the chaos, irrationality, and violent disequilibrium to which markets often seem prone. The same can also be said of the regulators watching the system. We'll lower ourselves into the hidden caves of finance, with their “dark pools” navigated by swarms of high-frequency traders, and show how new ideas from areas such as complexity science and machine learning are providing analytic tools for visualizing and understanding the turbulent eddies of financial flows. Along the way, we will grapple with some of the philosophical and practical difficulties in modeling the financial system – and show how models are often used less for predicting the future than for telling a story about the present.
The authors are both Oxford-trained applied mathematicians, who have worked in a variety of industries but otherwise come to this project from different angles. Paul is a quintessential insider – named “arguably the most influential quant today” by Newsweek – but he is also (as visitors to quant forum wilmott.com will know) a longstanding critic of standard practices. David works primarily in the areas of mathematical forecasting and computational biology (he invented a program called “Virtual Tumour,” which gives you an idea). He has argued in a number of books that economics needs to take a similarly biological approach – and that our out-of-control financial sector is in serious need of a health check.
The Money Formula provides new insights into one of the largest, best-paid, but least-understood industries in the world – and the one with the most capacity to either help our future economic development or give it the financial equivalent of a cardiac arrest.
We begin by turning to the early 18th century, when France was seeking financial advice from a mathematician.
CHAPTER 1
Early Models
“Nature, and Nature's Laws lay hid in Night.
God said, Let Newton be! And All was Light.”
“Beelzebub begat Law
Law begat the Mississippi
The Mississippi begat the System (etc.)”
The mathematical models used by quants are based on ideas and concepts developed by generations of economists. They in turn were heavily influenced by physics. But is it really possible to model the markets as a kind of physical system, or is quantitative finance more like a set of mathematical tricks for betting on markets? This chapter traces the development of economics; looks at the basic assumptions such as equilibrium and rationality that have shaped both economics and finance; and considers the dual nature of quantitative finance, as exemplified by two men – John Law and Isaac Newton.
In 1705, Scotland was contemplating union with its neighbor England. The English economy was riding high, and Scotland's leaders thought this might be an opportune moment for a merger. However, not everyone thought hooking up was a good idea. One person who argued against it was the banker, gambler, and social climber John Law. He went so far as to propose an entirely new monetary system for Scotland, which he claimed would go beyond the English system and in a stroke solve his country's monetary problems while boosting trade.
Part of England's success was due to its newly created central bank, the Bank of England, and efficiencies created by the introduction of bank notes. However, Law thought he could do better. According to him, the problem with this new English paper money was not that it was too radical, but that it was not radical enough, since it was still exchangeable for gold. Its supply was therefore determined not by the needs of the economy, but by the quantity of precious metal that happened to be in circulation at the time. In his text Money and Trade Consider'd with a Proposal for Supplying the Nation with Money, he argued that Scotland needed a central bank of its own, that issued its own paper currency, but one that was backed only by the state rather than by precious metal. After all, according to this son of an Edinburgh goldsmith, money was just a “Sign of Transmission,” like a casino chip, and not a store of real wealth.
The stakes for Law were greater even than the questions of Scottish independence or the meaning of monetary value. Ten years earlier, he had been charged with murder following a duel in London. After being imprisoned, he soon escaped and fled to Amsterdam. For several years he had toured around Europe, supporting himself and his young family by gambling (a trained mathematician, he claimed to have a system), before returning to Scotland. But if that country joined with England, he would have to leave or find himself back in jail.
This time, the dice did not fall in Law's favor. His radical monetary proposal was rejected by parliament, the union with England went ahead, and Law was again on the run from the law.
He set himself up in Paris, playing cards at all the fashionable salons. His system was extremely successful – so much so that he drew the attention of the Chief of Police, M. d'Argenson, who expelled him from the city. Again he hit the road, touring through Germany and Italy in a coach, amassing considerable wealth from his winnings; his prowess at gambling becoming something of a legend. When the “Sun King” Louis XIV died, leaving his country with a massive debt (incurred from wars and the construction of his palace at Versailles) and a bankrupt treasury, Law saw an opportunity and returned to France. There was a shortage of money, and he had the answer. He quickly won over the regent, Philippe d'Orléans, who took a chance on the Scotsman and appointed him as Controller General of Finances – perhaps with the hope that his “system” would work as well for the economy as it did at cards.
Law's plan for the country – and he did not lack ambition – consisted of two parts. The first was to set up a state bank financed initially by himself, the Banque Générale, that would issue paper money redeemable in gold or silver. The bank was hugely successful, and its notes soon attracted a premium just for their convenience over coins. The second, which followed two years later, was to establish a
