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Books And Books

The books I like to read may not always be the books I like to write. I like to read Michael Lewis but I am not sure I would like to write those type of books. It´s great to read story-telling, but perhaps not so great to write story-telling. There´s no philosophy, no critique, no praise, no recommendations, no idealism in plain story-telling. I mean Liars´Poker and The Big Short are great masterpieces but all they do is entertain. They don´t provoke too much thought, they don´t aspire to stir the pot, to change things, or to keep them as they are. They don´t have a viewpoint, they don´t make you want to join a battle. They don´t impact the world (nor do they seem to want to).

No one gets angry (bar perhaps Salomon´s bigwigs and that Wing Chao guy who´s suing ML) after reading those tomes. No one gets elated. No one gets excited. No one gets moved. No one is inspired. There are no calls for revolution or for counter-revolution. The status quo is neither lambasted nor defended. It´s all very plain vanilla. In a very pleasant way, but no tutti frutti.

That´s not to say I wouldn´t love to do a story-bio kind of book (or that I wouldn´t kill to have ML´s talents), but in that case I would try very hard to be normative as well as positive. Not mere describing, a bit of extra meat too. Some stirring of the pot. More Niall Fergusonish or Paul Kennedyish. There´s got to be some profound conclusion, even if the rest of the book is just narrating things that happened. A look towards the future, too. A book that creates loyal friends and terrible foes.

Having said all this, the written English I´ve enjoyed most to this day is ML´s collections of uber-descriptive essays assembled under "The Money Culture".

Derman and I

I notice that Emanuel Derman is about to release his new book. The tome seems to deal with how the failings of finance theory can impact the world. This sounds very close to what my Lecturing Birds attempted to do. There are big differences though.

For one, Derman knows much more than I do about the subject matter.

He is also a better writer.

But I suspect that there is an area where I may have a slight comparative advantage. I am an amateur, a dilettante, a stranger in a strange land. Derman is a pro in the field. While he is way more open and honest than most other pros in this debate, he may not want to be more open and honest than necessary. In other words, he probably can´t or doesn´t want to be a denunciator. He can´t or doesn´t want to be too critical or too cynical. I, on the other hand, was able to be stringently accusatorial because I had no allegiance but to the evidence I unearthed and what such findings dictated me to conclude. Derman can highlight VaR´s weaknesses but he might not want to call for its banning. Derman can talk about BSM´s flaws, but he might not want to embrace Taleb-Haug. Derman can denounce the unrealism of models but he might not want to lead a campaign against the (possibly impractical, probably lethal) modelling of finance.

So I eagerly await the release of Derman´s new pearl. I have no doubt that it will make for brilliant and enlightened reading. But I don´t expect to find any calls for revolution. I don´t expect any statement a la "models can be so demonstrably dangerous that we should actively protect the world from them". And that, in a way, is a pity. For Derman can garner many more followers than my humble Lecturing Birds ever could. He, as an elite member of the practising and teaching quant community, could be the messiah that parts the waters and leads the many towards a paradise land where implacably destructive mathematical trickeries don´t wreak untold economic and social havoc.

Why I Wrote Lecturing Birds On Flying

One “Peter” has, in a popular quanty site, posted less than amicable comments about my persona and my humble musings. I don´t know who Peter is. I know that there are several well-known quants whose names begin with Peter. Maybe one of those Peters is “Peter”, I am not sure.

Let me try to offer an adult response to “Peter”´s rather infantile rants. First of all, and as “Peter” aptly emphasizes, I am a stranger in a strange land. I am a non-quant non-theoretician who´s infiltrated the mathematical finance sphere for the past three years, via my Lecturing Birds On Flying and several models-doubting articles. I have never produced a mathematical paper or taught a math-heavy course. My direct experience with the quanty universe is limited to my student days, to my days as a derivatives marketer, and to the brief period when I dated a New York girl who had just dated a (rich) quant. I am not a quant, and have never pretended otherwise. In fact, I thank “Peter” for reproducing those parts of my book where proper disclaimers can be found.

The key issue, then, becomes: can a non-quant non-theoretician write a book dealing with finance theory and quantitative finance? Sure, why not? Many great tomes have been authored by people without direct membership in the world that´s being described. The best books on LTCM were penned by a general journalist with no markets experience, and by a financial journalist with no markets experience (but, granted, high-level science background); and those were wonderful efforts. Michael Lewis has written fantastic books dealing with fields as alien to his professional background as football, baseball, politics, the internet, and Subprime CDOs. Non-academic journalists John Cassidy and Justin Fox have compiled good chapter after good chapter on the history of financial economics. Peterson from the WSJ wrote “The Quants”, even though I have a feeling he couldn´t personally be further away from quantyland. Someone has recently produced a bestselling bio of Cleopatra, even without being Egyptian, having ever met the lascivious vixen, or having ever participated in the construction of a pyramid.

Compared to those efforts, Lecturing Birds could almost be accused of having been written by an uber expert. Again, I spent several years studying the tools (I got an A in stochastic calculus!), I read some of the key textbooks (Musiela, Shreve´s class notes, Neftci, Wilmott), I read Risk magazine, I read (and almost understood) Taleb´s Dynamic Hedging, I read Derman´s My Life As A Quant, I built an exotic options calculator that was used by NYU students, I have taught advanced derivatives at top international schools, I have published in Risk, I have published with Risk Books and Wiley, I read Fisher Black´s Biography, I read Capital Ideas, I have met some of the world´s top financial economists and mathematicians, I have sold exotic derivatives, I have professionally interacted with top-bank quants, I have read tons of research papers, and, last but not least, I´ve been fortunate to have dinner with leading theory-agnostics Nassim Taleb and Espen Haug. In other words, this non-quant had quite a lot of ammunition at his disposal to write a book subtitled “Can Mathematical Theories Destroy The Financial Markets?”, plus his intellect was sizable enough to pick up new stuff as things evolved (Gaussian Copula stuff, VaR stuff).

In any case, what I am trying to say is that you don´t need to have had first-hand direct experience in a field to successfully muse about happenstances pertaining to that field, provided that you are resourceful and intelligent enough to find good sources and to learn on your own. Bestselling authors do it, and have done it, all the time. Did that guy Chernow ever ride with George Washington? Certainly not. Does that diminish the value of his work? Certainly not. Should we doubt his conclusions because of that? Certainly not.

What you should do is make clear from the get-go what your possible limitations may be, and that I do in spades in Lecturing Birds, as “Peter” so graciously remains us. If I am not a bona fide citizen of quanty land, why then did I sacrifice my time for this endeavor? Because the topic was too relevant to ignore, too influential to abandon. Once it became clear that flawed, yet widely popular, models had contributed to the 2007 crisis there was no option but to spread the word. Just like there was no option but to try to summon the world into seriously considering the proper role (if any) of quantitative finance models going forward.

Lecturing Birds was aiming at a serious, adult, responsible audience that, even if perhaps in profound disagreement with my dictums, would rise to the occasion and focus on the unavoidably serious themes under consideration. I am pleased to say that some top quantitative priests did regale us with value-adding commentary, gentleman scholars like Steven Shreve and Aaron Brown who are more than capable of rebutting an argument without recourse to cheap, unintellectual, childish ad hominism. But “Peter” (like many others who´ve displayed similar behavior towards the book) doesn´t seem to have the same gravitas, appearing as a much smaller figure than those two giants.

The stakes are too high to waste our time with tired and empty ramblings. This was supposed to be a debate for grown-ups.

Donald Van Deventer´s Self-Serving And Childish Critique

This is what Donald Van Deventer (apparently one of the godfathers of quantitative risk "management") has to say about my Lecturing Birds On Flying:

"This book is the risk management equivalent of someone who says automobiles are useless because a few drivers crashed. The author has absolutely no understanding of risk management in either theory or practice. Don't waste your money"

Pretty adult stuff, uh? Is that how far your PhD in Business Economics from Harvard can take you, Don? No need to deal with the issues head on, is there? No need to actually try to rebut my arguments, right? Let´s just take the easy path of cheap ad hominism. Your sophistication is illuminating, Don. Absolutely awe-inspiring. But of course you are an Ivy Leaguer.

Actually I am grateful for Don´s ridiculously empty attack. It confirms that which I of course strongly suspected: I AM RIGHT, and my book is right. And that bothers Don and his peers very very much. After all, as Taleb has said many times, their entire business is being threatened. Don´s childish, issues-skirting response tells me that Lecturing Birds has bothered those bent on preserving the quantification of finance without regards to the collateral damages or the actual soundness of the math, and that does not bother me one bit. They don´t want the message being spread out, and that makes me smile.

I can actually borrow from Don´s analogy and, boomerangishly, throw it back at him. You see, Don, unlike most (all?) quant finance models, automobiles in fact do provide an unquestionably useful service and thus were an unquestionably relevant and needed innovation; also unlike quant finance, automobiles don´t have a tendency to structurally fail, they actually work pretty well; and, too in sharp contrast with quant finance concoctions, in those occasions when automobiles are shown to be defective they are immediately taken out of circulation, not preserved and ceasessly peddled and promoted. What Don and his peers are proposing is the equivalent of Toyota NOT recalling those deleteriously malfunctioning Lexus, instead keeping them on the road (keeping them harming people) so that the engineers who work on the cars don´t lose their status and paychecks. How´s that for responsible risk management!

The quant finance models that I criticize in my book ARE in fact utterly useless because they have a structural, inbred, unavoidable tendency to crash. In fact, they are worse than useless, as they can cause lots of malaise. What kind of individual would promote and peddle useless stuff that can cause trouble, Don?

Did you actually read the book, Don? If so, why don´t you step up and confront the real issues, some of which I am happy to list for you below: - BSM is deeply flawed and can cause trouble and has caused a lot of trouble - VaR is deeply flawed and can cause trouble and has caused a lot of trouble - Reliance on Normality, variance, correlation, expected return is deeply flawed and can cause trouble and has caused a lot of trouble - The last three mayor market crisis were all aided, abetted, and caused by the widespread use of flawed quantitative models - Using VaR as the regulatory measure for trading capital charges is a huge mistake that leads to the (hidden) build up of lethal risk trough massive leverage - BSM was given the Nobel for something that doesn´t (can´t) work in real life and that is based on insultingly erroneous assumptions - Flawed models are embraced by otherwise no-nonsense pros as alibis for reckless, otherwise not permitted, behavior; that is, if analysts are oftentimes known as the “whores of banking”, complicit financial mathematicians would in fact become…well, you fill the blanks - Quantitative risk management has not demonstrably solved any priorly unsolved problem, while creating lots of new, otherwise non-existent, problems

Not a single critic of my book and ideas (bar for perhaps the formidable Aaron Brown) has confronted the issues and tried to refute the above points (and many more). Not a single one. And these guys, a la Don, all have PhDs from top unis. And yet, all they seem to be able to do is fire mud at my face, in a decidedly un-Ivy League manner. Didn´t they have debate class at Harvard, Don? Or is it that mad quant finance folk can do only two things, namely draw equations and hurl cheap aspersions?

If you read my book you´ll see that one of my intentions (a main intention) was to humbly contribute to the kick-starting of a serious and mature debate on the true merits of quant finance, so that both sides can try to reach a healthy understanding for the sake of the markets’ and the economy´s health (not to mention the actual relevance of academic research). Given Don´s and his peers´ infantile reactions, it is obvious that, so far at least, I have not succeeded. Perhaps I made the mistake of assuming that I was talking to adults.

Don´s critique of Lecturing Birds adds absolutely nothing to this most important of debates. Alike his friends (all 100% dependent on the quant stuff remaining around in financeland; the banning of the models must be avoided at all costs, lest some people may have to go back to being the lowly college professor at family reunions as opposed to the one who made it to Wall Street), he seems incapable of even defending his own point of view. He can´t even stand up and shout “VaR is great, the most glorious invention of all times” or “Quantitative models had nothing to do with the credit crisis”. And that´s because, well, he really can´t. Unless he is willing to lie through his teeth that is.

Don is so coarsely rustic that he doesn´t even realize that in my book I don´t dismiss all quantitative finance efforts, but rather point out that there are several demonstrable episodes of horrible malaise caused by certain (rather quite famous) models and that such malfunctioning vehicles should be terminally recalled, and that we should be watchful going forward and ruthlessly terminate any future malfunctioning model, and that that should involve a comprehensive across-the-board no holds barred re-examination of the need for models.

Don´s critique is that of a child. Or, as Nassim would put it, that of a half-man. This debate is far too serious to be left to childish whinging. Don´t waste your time on Don.

On Jodaism - A Reply To Aaron Brown

First of all, let me say that I am honored that someone of the stature of Aaron Brown decided to review my Lecturing Birds on Flying. Having clarified that, I wish he had chosen a more regular venue for said exercise; is more than fine, but whatever happened to GARP Risk Review, Wilmott Mag, or the WSJ? Given Brown´s excellent writing skills I for one would have loved a lengthier, more formal take on my humble tome.

But a shortish, informal review on Amazon is all we´ve got, so let´s face reality and delve into the analysis. The review is a mix of positive and negative assessments. Such apparently unenthusiastic response may throw some authors back, but not me. I am too busy glowing in the fact that Brown finds good stuff buried within all those bothersome inverted pluperfect subjunctives (he says I remind him of Joda, of Star Wars fame). I can proclaim that I wrote a book that Aaron Brown found (somewhat) useful. That´s a very good thing. For not only is Brown a very prominent risk professional, or a very gifted and thoughtful "financial intellectual". He is also a renowned defender of the quanty stuff. So when someone like that is willing to compliment a book that goes heavily at the quanty stuff, you know that at least something has been done right (of course, I personally believe that a lot in the book is right).

Let´s stop basking in short-lived, modestly-served glory, and turn our attention now to Brown´s criticisms. He claims that I lose out to BSM, VaR, and other theoretical "straw men", that my views are deeply misinformed. I beg to differ. I think here I have the advantage of not being a quanty type and thus of having taken the approach of looking at the historical record and the opinion of other, much better informed, experts when analyzing the validity and wholesomeness of the best-known models, rather than try to engage them on mathematical grounds (though, naturally, I do attempt to dissect the essential technical deficiencies). So when I declare VaR a failure, I do so based on its behaviour during the credit crisis or during the Asian-LTCM meltdowns. I do it based on the monstrous shortcomings of the tool during crunch time out there in the real world. I think my book is the first ever to actually collect and display the actual data: what figures VaR registered, the number of exceptions incurred, how actual trading losses deviated from VaR. All that data comes straight from banks´ regulatory filings, a pretty solid source. I wouldn´t exactly call that misinformedness.

Same with BSM. My analysis of its role in the 1987 crash comes from official reports and other well-informed sources. My interpretation of what the volatility smile means in terms of the model´s reliability has been espoused by many through the years. And my summary of the Taleb&Haug paper is exactly that, a summary of a pretty trustworthy reference. So the foundations on which my lambasting of BSM rests also have the smell of solidity. I detect little misinformedness here too.

Brown says that risk management is not about predicting, but rather about preventing disasters. Fine, but then why use VaR? VaR is a predictor, with a degree of confidence. And VaR can´t, almost by definition, capture disasters. Many VaR lovers have, serendipitously, ceased to endow VaR with the predictor label following the (VaR-fueled, VaR-exposing) credit crisis. Upon seeing all those exceptions (80 real versus 5 theoretical in the case of UBS for 2007-2008, I seem to recall) it is only natural that they would want to deviate out attention from hitherto familiar arguments a la "99% VaR will not be exceeded more than twice a year". But that does not mean that I am wrong when, upon studying the hard evidence, I dare to proclaim that VaR failed monstrously.

Finally, Brown asserts that institutions with bad risk management fail only once. By that definition, VaR is clearly bad risk management. Anybody remembers Bear Stearns, Lehman Brothers, or Merrill Lynch? They used VaR for risk guidance and capital-charge setting. They had never failed in their entire combined history (three centuries?). All it took for such holly tradition to be broken was the concurrent abidance by a statistical tool that encouraged, allowed, and afforded the vast accumulation of the most toxic positions ever witnessed on Wall Street. VaR made sure that those legendary, erstwhile indestructible institutions would not fail a second time. When VaR kills you, it kills you for good.

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.