Jacket Design: Paul M c Carthy “ Finally, a book taking a critical look at quantitative fi nance models, illuminating both their fl awed fantasy assumptions as well as the uncritical use of such models on Wall Street, in many cases, leading to billion-dollar losses. Pablo Triana knows both the fi nancial industry and the academic community from the inside. A must-read for anyone interested in fi nance.” Dr. Espen Gaarder Haug, trader, thinker, and author of Derivatives Models on Models “ A thoroughly readable explanation of the problems that have beset the models and quantitative techniques that have underpinned so much of fi nance in recent years. If only the bankers had heeded this message a few years before, we might not be in such a big mess today.” Gillian Tett, Assistant Editor of the Financial Times, overseeing global fi nancial markets coverage, and author of Fool’s Gold “ Pablo Triana dismembers quantitative fi nance, in theory and in practice, with expertise, anger, and an excellent eye for the illuminating anecdote. By the time he has fi nished marshalling his evidence, his call to replace complex equations with something more like common sense sounds like, well, common sense.” Edward Hadas, Assistant Editor at Breakingviews.com; and author of Human Goods, Economic Evils: A Moral Approach to the Dismal Science “ Pablo Triana is an entertaining and engaging writer, even on the dry subject of fi nance theory. His debunking of conventional wisdom is a treat.” Pauline Skypala, Editor, FTfm, Financial Times “ Triana’s book is an unrelenting fusillade of detailed and irrefutable arguments against fi nancial theorems and those who teach them. It should, by rights, spark a revolution in both investment banks and business schools. But, at the very least, it is required reading for anyone who would regulate the fi nance industry.” Felix Salmon, Finance Blogger, Reuters LECTURING BIRDS ON FLYING CAN MATHEMATICAL THEORIES DESTROY THE FINANCIAL MARKETS? Triana $29.95 USA / $35.95 CAN or the past few decades, the fi n ancial world has often displayed an unreasonable willingness to believe that “the model is right, the market is wrong,” in spite of the fact that these theoretical machinations were largely responsible for the stock market crash of 1987, the LTCM crisis of 1998, the credit crisis of 2008, and many other blow-ups, large and small. Why have both fi nancial insiders (traders, risk managers, executives) and outsiders (academics, journalists, regulators, the public) consistently demonstrated a willingness to treat quantifi cations as gospel? Nassim Taleb fi rst addressed the confl icts between theoretical and real fi nance in his technical treatise on options, Dynamic Hedging. Now, in Lecturing Birds on Flying, Pablo Triana off ers a powerful indictment on the trustworthiness of fi nancial theory, explaining— in jargon-free plain English—how malfunctions in these quantitative machines have wreaked havoc in our real world. Triana fi rst analyzes the fundamental question of whether fi nancial markets can in principle really be solved mathematically. He shows that the markets indeed cannot be tamed with equations, presenting a long and powerful list of obstacles to prove his point: maverick unlawful human actions rule the markets, unexpected and unimaginable events shape the markets, and historical data is not necessarily a trustworthy guide to the future of the markets.  e author then examines the sources of origin of many prevalent theories and mathematical dictums. He details how the fi eld of fi nancial economics evolved from a descriptive discipline to an abstract one dedicated continued on back flap to technically concocting professors’ own versions of how such a world should work. He goes on to explain how Wall Street and other fi nancial centers became eager employers of scientists, and how scientists became eager employees of fi nancial fi rms. Triana concludes with an in-depth discussion of the most signifi cant historical episodes of theory-caused real-life market malaise, with a strong emphasis on the current credit crisis. In the end, Lecturing Birds on Flying calls for the radical substitution of good old-fashioned common sense in place of mathematical decision-making and the restoration to fi nancial power of those who are completely unchained to the iron ball of classroom-obtained qualifi cations. continued from front flap LECTURING BIRDS ON FLYING CAN MATHEMATICAL THEORIES DESTROY THE FINANCIAL MARKETS? Pablo Triana FOREWORD BY NASSIM TALEB Bestselling author of The Black Swan Praise for lecturing birds on flying PABLO TRIANA has successful derivatives ex- perience at all levels: on the trading fl oor and as a professor, consultant, and author. He is a frequent contributor to business publications, including the Financial Times, Forbes. com, Breakingviews.com, and Risk magazine, among others. Triana is also the author of Corporate Derivatives. He holds a master of science from the Stern School of Business, New York University, and a master of arts from American University. © Paloma Portela F P1: OTE/PGN P2: OTE fm JWBT103-Triana April 8, 2009 17:25 Printer Name: Yet to Come II P1: OTE/PGN P2: OTE fm JWBT103-Triana April 8, 2009 17:25 Printer Name: Yet to Come Lecturing Birds on Flying I P1: OTE/PGN P2: OTE fm JWBT103-Triana April 8, 2009 17:25 Printer Name: Yet to Come II P1: OTE/PGN P2: OTE fm JWBT103-Triana April 8, 2009 17:25 Printer Name: Yet to Come Lecturing Birds on Flying Can Mathematical Theories Destroy the Financial Markets? Pablo Triana John Wiley & Sons, Inc. III P1: OTE/PGN P2: OTE fm JWBT103-Triana April 8, 2009 17:25 Printer Name: Yet to Come Copyright C  2009 by Pablo Triana. All rights reserved. Foreword C  Nassim Nicholas Taleb. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. 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For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Triana, Pablo. Lecturing birds on flying : can mathematical theories destroy the financial markets? / Pablo Triana. p. cm. Includes bibliographical references and index. ISBN 978-0-470-40675-5 (cloth) 1. Finance. 2. Economics. I. Title. HG101.T75 2009 932–dc22 2009001895 Printed in the United States of America 10987654321 IV P1: OTE/PGN P2: OTE fm JWBT103-Triana April 8, 2009 17:25 Printer Name: Yet to Come To my parents, who gave me the perfect life. V P1: OTE/PGN P2: OTE fm JWBT103-Triana April 8, 2009 17:25 Printer Name: Yet to Come Too large a proportion of mathematical economics are a mere concoction, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols. —John Maynard Keynes, 1936 Because of the success of science there is a kind of pseudo-science, social science is an example, which is not a science. They follow the forms, they gather data and so forth, but they don’t get any laws, they haven’t found anything, they haven’t got anywhere (yet) Maybe I am wrong, maybe they do know but I don’t think so, I have the advantage of having found out how hard it is to really get to know something, how careful you have to be about checking the experiments, how easy it is to make mistakes. I know what it means to know something and therefore I see how they get their information and I can’t believe that they have done the works necessary, and the checks necessary, and the care necessary. I have a great suspicion, that they don’t know and that they are intimidating people. I don’t know the world very well, but that’s what I think. —Richard Feynman, 1981 Beware of geeks bearing formulas. —Warren Buffett, 2008 VI P1: OTE/PGN P2: OTE fm JWBT103-Triana April 8, 2009 17:25 Printer Name: Yet to Come ■ Contents ■ Foreword XI Preface: An Evening at NYU, Taleb’s Article, and a Credit Crisis XIX Mathew Gladstein’s Complaisance XLIII ESSENTIALS CHAPTER 1 PLAYING GOD 3 ■ It’s tough to model human action ■ Finance is not as religious as physics ■ Black Swans make things harder ■ The markets are not Normal and the past is a faulty guide ■ Should we care that theorists persist? ■ CHAPTER 2 THE FINANCIAL ECONOMICS FIEFDOM 29 ■ Virginity matters ■ When describing reality was okay ■ It’s the incentives, stupid ■ Many obstacles to reform ■ Heeding Fischer Black’s message ■ CHAPTER 3 QUANT INVASION 59 ■ Machine learning comes to finance ■ It’s a computational thing ■ Models live here, too ■ Quant punting ■ Interesting enough for a movie ■ VII P1: OTE/PGN P2: OTE fm JWBT103-Triana April 8, 2009 17:25 Printer Name: Yet to Come ■ VIII ■ CONTENTS CRITIQUE CHAPTER 4 COPULATED NIGHTMARES 93 ■ Abrupt reform, if not so much prison ■ Modeling death ■ The 2005 pre-warning ■ Rating us into hell ■ A disapproving grin ■ CHAPTER 5 BLAH VaR BLAH 127 ■ Insalubrious charlatanism ■ Tracking a true culprit ■ Credit truths ■ A long rap sheet of evidence ■ The police are in on it ■ CHAPTER 6 BLUE IS NOT GREEN 161 ■ Lehman did die ■ Anything is possible ■ Buffett versus the Black Swan ■ Stubbornly holding the theoretical fort ■ An end to indoctrination ■ CHAPTER 7 THE BLACK-SCHOLES CONUNDRUM 177 ■ Once upon a time at MIT ■ Frowning, not smiling ■ How Black was that Monday ■ A devastating KO ■ The Taleb & Haug critique ■ CONCLUSIONS CHAPTER 8 BLACK SWAN DECEIT? 245 ■ The tired “perfect storm” alibi may be a facade ■ Indoctrinating clients and investors ■ The unseemly marketers of academic dogma ■ Do as I say, not as I do ■ Glorifying complexity ■ [...]... pressures, fumbled their way into a heuristic option pricing formula: Those who liked to short out-of-the-money options blew up in time; those who bought them survived Traders knew what the heuristic “delta” was—about half for an at-the-money option, progressively less for an out-of-the-money option Indeed, in our paper we interviewed veterans who confirmed that option traders in Chicago priced “off the ■ XIV... option traders priced options without formulas Traders were robust to the Black Swans, these sudden events that are the scourge of option traders In that respect, Black-Scholes-Merton was a dangerous regression It was made only to accommodate the financial economics establishment and portfolio theory by showing how dynamic hedging removed the price of risk—a Platonic thought experiment that was beyond... fancy mathematics Robert Merton’s book Continuous Time Finance contains 339 mentions of the word theorem (or equivalent) An average physics book of the same length has 25 such mentions Yet, while economic models, it has been shown, work hardly better than random guesses or the intuition of cab drivers, physics can predict a wide range of phenomena with tenth-of-a-decimal precision They make you believe... practical use Old traders (pre-1973, when BSM was released) already knew how to trade, price, and risk-manage option positions, in many cases in a very savvy way In any case, very similar (and less constrained) models were already in existence Most importantly, option prices may be simply the result of good old-fashioned supply-demand interactions and elementary arbitrage relationships, with no complex... reality Only if the former were more complex, we could have avoided the worst The solution, then, is to up the analytical ante and get busy designing even more super-charged constructs that borrow from even more super-charged mathematical and computational tools Hire more PhDs, place even more weight on theorizing Keep glorifying the “physics-ization” of business schools To add a cherry on top, the pro-modeling... sophistication may have in the end been nothing more than a convenient excuse for reckless P R E FAC E ■ XXIX ■ behavior, a use-and-dump enabler for self-serving rogues who couldn’t care less about the equations None of these conclusions bodes well for theorists and their presumed relevance If the models were useless in preventing such a big impact event (which has claimed thousands of casualties among those... doubter of theoretical conventionalisms Taken together, Taleb’s take-no-prisoners critique and Simons’ clarifications, delivered within a few weeks of each other, appear as earthshatteringly impacting Surely, many had previously voiced complaints about the unworldliness of many a financial theorem or a mathematical finance construct But, unless I recall incorrectly, such concerns proved only mildly influential... bravely confront your dogmatic confronters, here are some tips that may prove useful First of all, everyone with a brain who lives in a nation where freedom of speech is not officially persecuted is entitled to their opinion, naturally, and to opine about the main, basic, irrefutable essentials of financial theory and the potential practical effects of ideas and tools built on such foundations Second, there... October 1987’s “Black Monday” and again on several occasions afterwards as the modelinspired dynamic hedging practices by option traders have seriously disturbed underlying markets from time to time Risk measuring standard tool Value at Risk (VaR) has also been portrayed as mayhem-enabling Mark-to-model disasters associated with complex derivatives have not gone unnoticed, either But, once more, no terminal... author of best-selling sensation The Black Swan are telling us, from their position as combined 30-year veterans of the trading floor front lines, is that, frankly, we never needed BSM at all While it may be of some mathematical beauty (it is hard to deny the innovations brought by the model when it comes to the tools, in particular the pioneer, and technically very smart, application of continuous time . in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Triana, Pablo. Lecturing birds on flying. substitution of good old-fashioned common sense in place of mathematical decision-making and the restoration to fi nancial power of those who are completely unchained to the iron ball of classroom-obtained. for lecturing birds on flying PABLO TRIANA has successful derivatives ex- perience at all levels: on the trading fl oor and as a professor, consultant, and author. He is a frequent contributor