About 40 pages into The Money Formula, by Paul Wilmott and David Orrell, you start wondering why would someone write another book on investments that forces us to read about all the characters and theories connected to the world of investing—from Isaac Newton (who lost money in the South Sea Bubble, the earliest market crash), to John Law’s monetary gamble with the French exchequer, to Loius Bachelier’s thesis at the turn of the previous century on speculation, to the Chicago School in the second half of the 20th century which spun its theoretically ‘elegant’ but completely useless efficient market theory, to modern portfolio theory (MPT) of Harry Markowitz, etc. I have comes across dozens of books which take us through this obligatory tour before coming the to point. Perhaps, since the field of investment theory is small and ‘circumscribed’ (in the words of Dr William Bernstein, a neurologist and an outstanding writer on investing)!
It is well known that the biggest influence on modern finance has come from the Chicago School’s efficient market hypothesis (EMH), MPT, capital asset pricing model and valuation of options. All these theories are ‘mathematically beautiful’ because what lies beneath them are neat assumptions: investors have access to the same information; they act in a rational manner and drive prices to an equilibrium between supply and demand. It is also well known now that these assumptions are balderdash. Investors suffer from biases. Charlie Munger, Warren Buffett’s partner, last listed 24 types of irrationality that all of us suffer from. It is these biases that drive prices and create volatility not rational people acting on self-interest driving prices to equilibrium. Investors hate losses more than they love their gains; this is why they hold on to poorly performing stocks. They go wild with exuberance in a bull market and are engulfed with pessimism in a bear market.
Quantitative finance started to become mainstream when option pricing theory was published in 1973 that came out of the academicians’ desire to reduce the complexities of the financial markets to neat formulae. The advent of computers enhanced the appeal of mathematical finance by making the calculations easier while allowing traders to trade faster and faster. It is another matter that these developments have made markets more interconnected and dangerous, leading to such things as flash crash and global financial crash.
This book is a witty survey of the world of quantitative finance. Paul Wilmott is one of the foremost names in this specialised field. He studied mathematics at Oxford, did a DPhil in fluid mechanics and now has a small business running a distance-learning course in mathematical finance, wilmott.com, a thriving website for quant community. He also runs a recruitment agency for quants and founded the journal Applied Mathematical Finance. David Orrell is a Canadian writer and a mathematician.
The book is divided into 10 chapters. The initial chapters describe the run up to today’s quantitative finance; it then gets into the core of the quant world: what quants do, what is wrong with the models and how the financial system has been abused. The final chapter deals with systemic threat. But the threat is not only from models and computers and bottom-line-driven hedge funds. The threat is also ominously from within which this story will prove.
In 2010, Paul was contacted by the UK treasury department worried about high-frequency trading (HFT) (the flash crash had just happened in the US). He made six key points. At the meetings, various solutions were discussed. One of them was to apply circuit-breakers to stop the market if the price crashed below a certain level. Paul objected to this idea saying that hedge funds, surely, would find a way to game the system. A year went by and Paul assumed that this was just how committees worked—inefficiently and slowly. But then he got curious and sent a follow-up query. Another meeting followed. The committee members explained to Paul that he was seen as too academic.
The “incredibly charming civil servants” found a way to dump him from the committee. In 2012, the final report came out. “To put it briefly,” write the authors, “the finding of the experts was that everything is fine. High-frequency and computer trading are nothing but good for everyone. Nine proposals had been made for pruning the impact of HFT, seven were deemed unnecessary or problematic. Of the remaining two, one stood out. The experts were in agreement that circuit breakers were a good idea.” The industry had managed to influence the treasury to see things their way by getting the officials to weed out people like Paul from the committee.