Paul Wilmott, David Orrell
The Money Formula: Dodgy Finance, Pseudo Science, and how Mathematicians Took Over the Markets
This edition first published 2017
© 2017 Paul Wilmott and David Orrell
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ISBN 978-1-119-35861-9 (paperback) ISBN 978-1-119-35866-4 (ebk)
ISBN 978-1-119-35868-8 (ebk) ISBN 978-1-119-35872-5 (ebk)
Cover design concept: Beatriz Leon
To Oscar, Zachary, Genevieve, and Horatio
To Wendy and Katherine
Acknowledgements
The authors would like to thank publisher Thomas Hyrkiel, project editor Jeremy Chia, production editor Samantha Hartley, and the rest of the Wiley team. Thanks also to Seth Ditchik, Ed Howker, Julia Kingsford, Robert Lecker, Beatriz Leon, Robert Matthews, Myles Thompson, and Andrea Wilmott.
About the Authors
Paul Wilmott is a mathematician and serial entrepreneur. His textbooks and educational programs provide the definitive training for quants; his website wilmott.com is the center of the quant community; his eponymous bi-monthly – and according to Esquire the world's most expensive – magazine is a quant must-have. As a practitioner he has been a consultant to leading financial institutions and managed his own hedge fund. As a commentator he has appeared on many TV and radio programs and written OpEds for the New York Times. Nassim Nicholas Taleb calls him the smartest quant in the world: “He's the only one who truly understands what's going on… the only quant who uses his own head and has any sense of ethics.” Paul divides his time between London, the Cotswolds, and New York.
David Orrell is an applied mathematician and writer. Founder of the scientific consultancy Systems Forecasting, his scientific work has encompassed diverse areas such as particle accelerator design, weather prediction, cancer biology, and economics. His books on subjects including prediction, economics, and science have been national bestsellers and have been translated into over ten languages. A revised and expanded version of his book Economyths: 10 11 Ways That Economics Gets it Wrong is also published this year. He lives in Toronto.
Introduction
“How about the scandalous stories of thousands of families with small and medium investments who have been ruined because of the greed of financial institutions in the United States and Europe. Look at the evictions, ruined families, and suicide attempts caused by the financial crisis of those who have failed to control the capital markets or the prices of raw materials. ¡Vaya mierda!” 1
“The truth about their motivation in writing.”
The global financial crisis that peaked in late 2008, and whose aftershocks have yet to fully dissipate, was the culmination of many years of dubious financial practices. If carried out alone they might have caused only localized harm, but they became aligned in the way that only the most dramatic of astrologers can dream of: a quadrillion dollars in complex financial products that no one understands; risk-management techniques that hide risk rather than decrease it; moral hazard and dangerous incentives; lack of diversification; regulators that are oblivious; mathematicians acting as psychological enablers. It was a story where the naïve, the negligent, and the downright nasty all pulled together in seizing as much as possible for themselves while almost destroying the financial foundations of the planet.
Of course, things have moved on since then. The banking system has become even more concentrated. Global debt – the engine fuel of finance – has grown to unprecedented levels. Markets, in which activity is increasingly dominated by high-frequency-trading robots, experience constant “flash” events where prices suddenly go wild before returning to more normal levels. The world financial system is once again rattling at its cage, ready to blow. And quantitative finance – the use of mathematical models to assist or dictate investment decisions – has become more powerful and influential than ever.
The story, in other words, isn't over – not by a long shot. Indeed, the stakes have never been higher, which is why previously arcane topics such as hedge funds, high-frequency trading, and too-big-to-fail banks have become a major topic of often-confusing debate for everyone from TV pundits to politicians. And why the confusion is often deliberate.
It has been estimated that in 2010 the notional value of all the financial derivatives in existence was $1.2 quadrillion.2 That's $1,200,000,000,000,000. For comparison, it's about 17 times the market capitalization of all the world's stock markets, or 150 times the value of the above-ground gold supply, or $170,000 for every living human on the planet. Actually, it's larger than the entire global economy. We'll explain this number, and how it could be interpreted, later. For the moment, let's just say that whatever it means in terms of risk, it seems like a dangerously big number for what is, let's be honest, just a service industry.
This book is not about the fallout from the crisis – plenty of books and column inches have been written about that – but about helping to prevent the next one (which won't look like the last one). To do that, it is necessary to go into the engine room of this massive shadow economy and understand how quantitative analysis works. How do you create a quadrillion