Financial crisis has deep roots in academia
Exotic mathematical models were devised by those who had no practical knowledge of the markets yet decided they knew better than the traders how markets operated, author Pablo Triana writes.
By Morgen Witzel
September 7, 2009
Should the Nobel Prize for economics be abolished? That is one of the suggestions in Pablo Triana's provocative book "Lecturing Birds on Flying: Can Mathematical Theories Destroy the Markets?"
Triana, formerly a derivatives trader and academic at the University of Madrid, makes a simple assertion. Financial models, such as value at risk and the famous Black-Scholes-Merton model, which won its founders a Nobel, have done more harm than good.
"Make no mistake, quantitative finance had a very large hand in what could well be the worst financial crisis in the history of mankind," he writes.
Triana's book is a critique bordering on an assault on mathematical, or quantitative, finance.
From the opening chapter, "Playing God," Triana maintains that the fundamental assumptions on which mathematical finance theory are based are wrong. Yet the theory continues to hold sway.
And the biggest villain of the piece is the financial academic establishment. Much of its work, he says, has been unnecessary. Before mathematical finance, traders had working models for things such as option pricing. By and large, these models were effective and accurate.
Then came the Black-Scholes-Merton model, which Triana says does not work and was also largely responsible for the 1987 stock market crash. What is more, he maintains, most traders know it does not work and only pretend to use it because finance theory is fashionable and criticizing the model is a heresy.
This is not the only case. The Gaussian copula model, which was intended to measure default probability, failed to identify toxic structured securities and led to massive errors in valuation and credit ratings, Triana says. Likewise, the value at risk model "failed to measure risks even half-accurately and, worse, decisively encouraged and sanctioned the wild risk-taking that brought Wall Street (and consequently the world) down."
Old-fashioned common-sense methods were replaced by theoretical models based on math, developed by people who had no practical knowledge of markets yet decided they knew better than the traders how markets operated.
Hence the book's "lecturing birds on flying" title. And, he says, everyone falls for this -- including the traders themselves. Finance academics continue "churning out quantitative hodgepodge" and Wall Street and others continue to use it.
Triana devotes a chapter to the "quants," the mathematicians and physicists who became influential in many big finance houses and imported quantitative academic models with them. For a time, employing quants was trendy: It showed the firm was using science to beat the market.
But the market had its revenge.
"Markets can't be tamed with equations," Triana writes. "Maverick, unlawful human action rules the markets, unexpected and unimaginable monstrous events shape the markets."
But in the end, he wonders whether people will ever come to terms with this.
In one chapter, "An Unhealthy Yearning for Precision," Triana writes that our "fear of the unknown and our desire for certainty lead us to throw ourselves into the arms of perceived 'experts.' . . . We trust quantitatively flavored constructs to escort us away from the gloomy reality of unmeasurable uncertainty."
But they are leading us in the wrong direction, he says. As Nassim Nicholas Taleb writes in his witty introduction to the book, giving someone the wrong map is worse than giving them no map at all.
Readers of this book may make quite a lot of noise -- I know I did. Some will cheer out loud; others will yelp as cherished beliefs are torn into shreds. At times, the book is deliberately incendiary. Triana is trying to stimulate debate.
On the whole, "Lecturing Birds on Flying" is a good read. Some may find the elaborate prose closer to Cervantes than to, say, Nobel Prize winner Robert Merton -- annoying. But perhaps Cervantes is the right writer to emulate when tilting at windmills.
For it seems likely that, no matter how hard observers such as Triana and Taleb try to demolish it, mathematical finance is not going away.
Morgen Witzel is a frequent contributor to the Financial Times of London, in which this review first appeared.
Financial crisis has deep roots in academia - latimes.com
