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Wednesday, 6 June 2012

Pricing the Future

Posted on 12:58 by Unknown
My review of George Szpiro's Pricing the Future: Physics, Finance and the 300-year Journey to the Black–Scholes Equation is in this month's Physics World. I'll post a link to the review itself if and when they make an ungated version available. Until then you'll have to content yourself with the excerpts below (click for larger version). See related post with some notes I made for the review.





Financial Weaponry 

Almost every physicist or mathematician below a certain age knows a former colleague or classmate who now works in finance. Older scientists, however, can probably remember a time before such “quants” existed. What happened to create this new and lucrative profession over the course of a few decades? 
... Since the payoff depends on future events, any pricing model must include, at minimum, a probability distribution over future outcomes. But in fact the problem is more subtle, because the value of a given probability distribution of future payouts to a particular individual depends on that individual’s attitude towards risk. ... 
... but experts are violently divided on the more general societal utility of advances in derivatives theory and practice. The conventional view, taught in business schools and in economics departments, is that financial innovation enables economic dynamism and allows markets to allocate resources more efficiently. The opposing perspective, held by none other than billionaire investor Warren Buffett, is that derivatives are "financial weapons of mass destruction" -- speculative instruments in a complex global casino that carry more risk than benefit. When Buffett’s company, Berkshire Hathaway, bought the reinsurance firm General Re in 1998, the latter had 23,000 derivative contracts. Buffett later explained his attitude towards these contracts to a US government panel: “I could have hired 15 of the smartest people, you know, math majors, PhDs. I could have given them carte blanche to devise any reporting system that would enable me to get my mind around what exposure that I had, and it wouldn’t have worked,” he said. “Can you imagine 23,000 contracts with 900 institutions all over the world, with probably 200 of them names I can’t pronounce?” Ultimately, Buffett decided to unwind the derivative deals, even though doing so incurred some $400 million in losses for Berkshire. 
The recent financial crises suggest that Buffett’s attitude may be the right one, and that the potential benefits of derivatives and other complex instruments come with dangerous systemic risks. At a recent meeting to address post-crisis financial reforms, the former chief of the US Federal Reserve, Paul Volcker, commented: “I wish somebody would give me some shred of evidence linking financial innovation with a benefit to the economy.” In Pricing the Future, Szpiro gives us a colourful history of derivatives, but does little to address Volcker’s fundamental question.
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