On Financial Remakes - A Reply To Satyajit Das

Let me first say that Satyajit Das presents two very worthwhile attributes: on the one hand he has written some of the very best books on derivatives (books that are actually useful and grounded on real-life stuff, and that offer things no other tomes offer; he is certainly not another dime-a-dozen me-too derivatives wannabe who wastes our time boringly, and solely, covering for the umpteenth time Ito´s lemma and Girsanov´s theorem); on the other hand, he has been out there around the block in the trenches for a long time (he is certainly not another dime-a-dozen me-too virging trying to lecture the derivatives porn stars; he´s done plenty of shagging in the real markets himself) He has recently reviewed my Lecturing Birds On Flying and Justin Fox´s Myth of the Rational Market and I would like to politely intrude and add some comments.

Let me first deal with Fox´s tome. I have been quite surprised at the tremendous success that said work has enjoyed and continues to enjoy. I met Fox more than two years ago in NYC and he mentioned that he had been working on the book for ages and that he couldn´t bring himself to finishing it. Myth was released a few months ago so I guess it took him more than five years to pen it. At the time, and to be perfectly honest, I thought to myself "Who needs a book on the history of the academic intrigue behind efficient markets theory?", I mean that business has not only been settled long ago (not even academics, let alone pros, believe in the theory any more!), but why bother with academic mental masturbation that no one in the real world really ever paid much attention to? Serendipitously, the release of Myth coincided like clockwork with the maturation of the credit crisis and the proliferation of texts trying to explain what happened. Miraculously for Fox, lots of media pundits very puzzlingly began to blame efficient markets theory for the mayhem, thus pointing in the direction of Myth for those in desperate search of an explanation. As I posit in a recent FT article, it is utterly unseemly to blame for this crisis a theory that no one cares for and that postulates that financial actors are rational and can´t beat the market (do you really believe that anyone inside a trading floor operates under the assumption that markets are rational and the old Fama was right and the new Fama is wrong? do you really believe that Subprime CDOs were accummulated in the name of efficient markets theory?) So Fox´s bestselling status, notwithstanding his many writting abilities, is a puzzle to me. But then again the book publishing business can be pretty unpredictable, so there´s often no way to tell. All that´s left to do is say "Mr Fox, I don´t understand why a book about a failed irrelevant decadently-neanderthalist theory has triumphed, but hey congratualtions and more power to ya".

Now on to my own Lecturing Birds. Das categorizes the effort as Taleb-revering. Well, hell yes. First of all, without Nassim´s encouragement these Birds would have never taken flight. Second of all, if you write a book about finance theory and its effects on the world and if you are honest you can´t but end up agreeing a whole lot with Taleb, not to mention quoting his work. It´s not only that I happen to agree with him, but you simply can´t write a book like Lecturing Birds without heavily borrowing from Taleb. But I wouldn´t call my book a remake of The Black Swan or FBR. While I certainly honor the spirit and main ideas of those hits, I cover many other things. My book is a combo of many things, discussing how financial theory and practice differ, how financial theory affects practice, who are the folks behind the theories and why they churn out theories, why pros may embrace theories, as well as a sizable dose of revolution-calling and debate-inciting. I think the book came out neat, could even perhaps become a classic of sorts. I like that fact that the chapters are self-contained. You can go and see the chapter on why markets can´t be tamed mathematically. Or the one on how the financial economics academic world operates. Or the one on the quants (who they are, where they come from, what they do, should we fear them). Or the one on the Gaussian Copula and its role in the crisis. Or the on VaR and its role in the crisis. Or the one on Black-Scholes and why it created trouble and why it´s not used. Or the one on the Nobel. Das, like everyone else it seems, is surprised by the writing style. I have been compared to Cervantes and denominated hopelessly convoluted by two of the most illustrated of English-speaking publications. Das goes one further and gives me responsibility for having created a new type of slang. So I think it´s time I add my take. First of all, I love the style. Why did it come out that way? Two reasons: I did want to overemphasize things and reinforce messages, this book has a lot of crusading aspects to it and I thought it improper to mince words and let timidity rule supreme, I wanted to relentlessly hammer down key points, I have also been accused of unbearable repetitiveness and I take that as a compliment a sign that says "mission accomplished" (besides, as Espen Haug reminded me, financial economists have been repeating their nonsense for decades and no one brought them to task, why can´t I engage in a bit of it myself). The second explanation for the style is that that´s how I wanted to muse at the time, it was me in the raw at that particular time, it was me uncontained and unconstrained, I was, frankly, having fun playing games with words (in Das´ terms, "experimenting with the extremities of the English language"), writing this book made me realize to the full how fun musing can be.

Finally, Das points at an apparent contradiction: I say that models can caused trouble yet with the same mouth pronounce that models are many times ignored by pros. There´s no contradiction here. I am simply stating a fact, painting the broader picture. Theory can in general be ignored and avoided and at the same time create untold damage on those specific instances where it is in fact used. VaR and Gaussian Copula were certainly employed by financial institutions, rating agencies, and regulators all over the world and such passionate embracing caused the crisis. 99% of theory may be deemed insultingly ridiculous by pros but that does not negate the fact that certain specific models have been embraced and led to chaos. Or take Black-Scholes. Yes, the market says the model´s a joke. I does not use it. And yet that undeniable truism does not erase the fact that Black-Scholes, on the occassion when it was used in force, unleashed the October 1987 hell (among other, lesser, dynamic hedging-related massacres). I am not saying that all theory is used, or that all theory is crap, or that all theory is lethal. I am saying that the worst market debacles since 1929 were caused by crappy theories let loose. The solution? don´t ever again employ crapy potentially-lethal theory. Das, as a seasoned pro (as a sceptical stud, not a naive virgin) knows full well that theories and theorists are typically not taken seriously in the real world of finance. So what explains those specific instances when models do rule supreme? Simple, from time to time there comes a mathematical construct that can serve as scientifically-smelling alibi to engage in the kind of activities that traders do love to engage in. The math may be deemed insufferably stupid by the pros, but that does not negate the value that they can cynically derive from it. And many quants and theorist are only too happy to take part in the bonus-seeking deceit. Among other things because they, too, want to have a taste of that Champagne.