Lecturing Birds on Flying

401 Pages·2009·2.66 MB·English

by  Pablo Triana

c o n t i n u e d f r o m f r o n t f l a p Triana
Praise for
$29.95 USA / $35.95 CAN
lecturing birds flying
to technically concocting professors’ own versions of how on F
C L
such a world should work. He goes on to explain how
A
or the past few decades, the fi nancial world has
Wall Street and other fi nancial centers became eager “ Finally, a book taking a critical look at quantitative fi nance models, illuminating both their N E
M often displayed an unreasonable willingness
employers of scientists, and how scientists became eager fl awed fantasy assumptions as well as the uncritical use of such models on Wall Street, in many C
A
to believe that “the model is right, the market
cases, leading to billion-dollar losses. Pablo Triana knows both the fi nancial industry and the T
employees of fi nancial fi rms. Triana concludes with an
academic community from the inside. A must-read for anyone interested in fi nance.” H T is wrong,” in spite of the fact that these theoretical
in-depth discussion of the most signifi cant historical E
Dr. Espen Gaarder Haug, trader, thinker, and author of Derivatives Models on Models M machinations were largely responsible for the stock
episodes of theory-caused real-life market malaise, with U
A market crash of 1987, the LTCM crisis of 1998, the
a strong emphasis on the current credit crisis. T
“A thoroughly readable explanation of the problems that have beset the models and quantitative I R credit crisis of 2008, and many other blow-ups, large
C
techniques that have underpinned so much of fi nance in recent years. If only the bankers had
In the end, Lecturing Birds on Flying calls for the radical A and small. Why have both fi nancial insiders (traders,
heeded this message a few years before, we might not be in such a big mess today.” L I
risk managers, executives) and outsiders (academics,
substitution of good old-fashioned common sense in place Gillian Tett, Assistant Editor of the Financial Times, overseeing global fi nancial markets coverage, T N
journalists, regulators, the public) consistently
of mathematical decision-making and the restoration to H LECTURING
and author of Fool’s Gold
E demonstrated a willingness to treat quantifi cations
fi nancial power of those who are completely unchained G
O
to the iron ball of classroom-obtained qualifi cations. “P ablo Triana dismembers quantitative fi nance, in theory and in practice, with expertise, anger, R BIRDS as gospel? Nassim Taleb fi rst addressed the confl icts
and an excellent eye for the illuminating anecdote. By the time he has fi nished marshalling his IE ON between theoretical and real fi nance in his technical
S B
evidence, his call to replace complex equations with something more like common sense sounds like, FLYING treatise on options, Dynamic Hedging. Now, in Lecturing

D I
well, common sense.” Birds on Flying, Pablo Triana off ers a powerful indictment
PABLO TRIANA E R
Edward Hadas, Assistant Editor at Breakingviews.com; and author of Human Goods, S on the trustworthiness of fi nancial theory, explaining—
T
has successful derivatives ex- Economic Evils: A Moral Approach to the Dismal Science R D CAN in jargon-free plain English—how malfunctions in
perience at all levels: on the O
© MATHEMATICAL these quantitative machines have wreaked havoc in our
P “P ablo Triana is an entertaining and engaging writer, even on the dry subject of fi nance theory. Y
alom trading fl oor and as a professor, His debunking of conventional wisdom is a treat.” T S THEORIES real world.
a P consultant, and author. He is a H
ortela frequent contributor to business Pauline Skypala, Editor, FTfm, Financial Times FE O DESTROY Triana fi rst analyzes the fundamental question of
I
publications, including the Financial Times, Forbes. “T riana’s book is an unrelenting fusillade of detailed and irrefutable arguments against fi nancial N N THE FINANCIAL whether fi nancial markets can in principle really be
A
com, Breakingviews.com, and Risk magazine, among theorems and those who teach them. It should, by rights, spark a revolution in both investment solved mathematically. He shows that the markets indeed
N
F MARKETS?
others. Triana is also the author of Corporate Derivatives. banks and business schools. But, at the very least, it is required reading for anyone who would C cannot be tamed with equations, presenting a long and
He holds a master of science from the Stern School of regulate the fi nance industry.” IA L powerful list of obstacles to prove his point: maverick
L
Business, New York University, and a master of arts from Felix Salmon, Finance Blogger, Reuters Y unlawful human actions rule the markets, unexpected and
M
American University.
A I unimaginable events shape the markets, and historical data
R N is not necessarily a trustworthy guide to the future of the
Pa blo Tr iana
Jacket Design: Paul McCarthy K
E markets. Th e author then examines the sources of origin
T G
of many prevalent theories and mathematical dictums.
S
? NASSIM TALEB He details how the fi eld of fi nancial economics evolved
FOREWORD BY
Bestselling author of from a descriptive discipline to an abstract one dedicated
T h e B l a c k S w a n
c o n t i n u e d o n b a c k f l a p
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Lecturing Birds
on Flying
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Lecturing Birds
on Flying
Can Mathematical Theories
Destroy the Financial Markets?
Pablo Triana
John Wiley & Sons, Inc.
III
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Copyright(cid:1)C 2009byPabloTriana.Allrightsreserved.
Foreword(cid:1)CNassimNicholasTaleb.
PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey.
PublishedsimultaneouslyinCanada.
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LibraryofCongressCataloging-in-PublicationData:
Triana,Pablo.
Lecturingbirdsonflying:canmathematicaltheoriesdestroythefinancial
markets?/PabloTriana.
p.cm.
Includesbibliographicalreferencesandindex.
ISBN978-0-470-40675-5(cloth)
1.Finance. 2.Economics. I.Title.
HG101.T75 2009
932–dc22
2009001895
PrintedintheUnitedStatesofAmerica
10 9 8 7 6 5 4 3 2 1
IV
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To my parents, who gave me the perfect life.
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Toolargeaproportionofmathematicaleconomicsareamereconcoction,asimprecise
astheinitialassumptionstheyreston,whichallowtheauthortolosesightofthe
complexitiesandinterdependenciesoftherealworldinamazeofpretentiousand
unhelpful symbols.
—JohnMaynardKeynes,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
gotanywhere(yet)...MaybeIamwrong,maybetheydoknowbutIdon’tthink
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.
—RichardFeynman,1981
Beware of geeks bearing formulas.
—WarrenBuffett,2008
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■ Contents ■
Foreword XI
Preface: An Evening at NYU, Taleb’s Article, and a
Credit Crisis XIX
Mathew Gladstein’s Complaisance XLIII
ESSENTIALS
CHAPTER 1 PLAYING GOD 3
■ It’stoughtomodelhumanaction ■ Financeisnotasreligious
asphysics ■ BlackSwansmakethingsharder ■ Themarketsare
not Normal and the past is a faulty guide ■ Should we care that
theorists persist? ■
CHAPTER 2 THE FINANCIAL
ECONOMICS FIEFDOM 29
■ Virginity matters ■ When describing reality was okay ■ It’s
the incentives, stupid ■ Many obstacles to reform ■ Heeding
Fischer Black’s message ■
CHAPTER 3 QUANT INVASION 59
■ Machine learning comes to finance ■ It’s a computational
thing ■ Models live here, too ■ Quant punting ■ Interesting
enough for a movie ■
VII
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■ VIII ■ CONTENTS
CRITIQUE
CHAPTER 4 COPULATED NIGHTMARES 93
■ Abrupt reform, if not so much prison ■ Modeling death ■
The 2005 pre-warning ■ Rating us into hell ■
A disapproving grin ■
CHAPTER 5 BLAH VaR BLAH 127
■ Insalubrious charlatanism ■ Tracking a true culprit ■ Credit
truths ■ A long rap sheet of evidence ■ The police are
in on it ■
CHAPTER 6 BLUE IS NOT GREEN 161
■ Lehman did die ■ Anything is possible ■ Buffett versus the
BlackSwan ■ Stubbornlyholdingthetheoreticalfort ■ Anend
to indoctrination ■
CHAPTER 7 THE BLACK-SCHOLES
CONUNDRUM 177
■ Once upon a time at MIT ■ Frowning, not smiling ■ How
Black was that Monday ■ A devastating KO ■ The Taleb &
Haug critique ■
CONCLUSIONS
CHAPTER 8 BLACK SWAN DECEIT? 245
■ The tired “perfect storm” alibi may be a facade ■
Indoctrinating clients and investors ■ The unseemly marketers
of academic dogma ■ Do as I say, not as I do ■ Glorifying
complexity ■