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Red-Blooded Risk: The Secret History of Wall Street

ISBN: 978-1-118-04386-8
432 pages
October 2011
Red-Blooded Risk: The Secret History of Wall Street (1118043863) cover image
An innovative guide that identifies what distinguishes the best financial risk takers from the rest

From 1987 to 1992, a small group of Wall Street quants invented an entirely new way of managing risk to maximize success: risk management for risk-takers. This is the secret that lets tiny quantitative edges create hedge fund billionaires, and defines the powerful modern global derivatives economy. The same practical techniques are still used today by risk-takers in finance as well as many other fields. Red-Blooded Risk examines this approach and offers valuable advice for the calculated risk-takers who need precise quantitative guidance that will help separate them from the rest of the pack.

While most commentators say that the last financial crisis proved it's time to follow risk-minimizing techniques, they're wrong. The only way to succeed at anything is to manage true risk, which includes the chance of loss. Red-Blooded Risk presents specific, actionable strategies that will allow you to be a practical risk-taker in even the most dynamic markets.

  • Contains a secret history of Wall Street, the parts all the other books leave out
  • Includes an intellectually rigorous narrative addressing what it takes to really make it in any risky activity, on or off Wall Street
  • Addresses essential issues ranging from the way you think about chance to economics, politics, finance, and life
  • Written by Aaron Brown, one of the most calculated and successful risk takers in the world of finance, who was an active participant in the creation of modern risk management and had a front-row seat to the last meltdown
  • Written in an engaging but rigorous style, with no equations
  • Contains illustrations and graphic narrative by renowned manga artist Eric Kim

There are people who disapprove of every risk before the fact, but never stop anyone from doing anything dangerous because they want to take credit for any success. The recent financial crisis has swelled their ranks, but in learning how to break free of these people, you'll discover how taking on the right risk can open the door to the most profitable opportunities.

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Acknowledgments xi

Chapter 1 What This Book Is and Why You Should Read It 1

Risk, Danger, and Opportunity 2

Red- Blooded Risk Management 4

Risk and Life 7

Play and Money 9

Frequentism 11

Rationality 13

Bets 15

Exponentials and Culture 18

Payoff 20

Chapter 2 Red Blood and Blue Blood 23

Chapter 3 Pascal's Wager and the Seven Principles of Risk Management 29

Principle I: Risk Duality 32

Principle II: Valuable Boundary 33

Principle III: Risk Ignition 35

Principle IV: Money 38

Outside the VaR Boundary 40

Principle V: Evolution 45

Principle VI: Superposition 48

Principle VII: Game Theory 49

Chapter 4 The Secret History of Wall Street: 1654– 1982 57

Pascal and Fermat 58

Poker 61

Advantage Gamblers 62

Sports Betting 63

Quants to Wall Street 66

Finance People 68

Real Finance 69

Chapter 5 When Harry Met Kelly 73

Kelly 74

Harry 76

Commodity Futures 79

If Harry Knew Kelly 84

Investment Growth Theory 88

eRaider.com 92

MPT Out in the World 96

Chapter 6 Exponentials, Vampires, Zombies, and Tulips 101

Types of Growth 102

The Negative Side 105

Tulips 106

Tulip Propaganda 108

Quantitative Tulip Modeling 111

Money 112

Chapter 7 Money 117

Chapter 8 The Story of Money: The Past 125

Property, Exchange, and Money 126

Paleonomics 128

Transition 131

What Money Does 134

Risk 135

Government and Paper 138

Paper versus Metal 142

1776 and All That 145

Andrew Dexter 147

A Short Digression into Politics and Religion 150

Chapter 9 The Secret History of Wall Street: 1983– 1987 155

Effi cient Markets 157

Anomalies 159

The Price Is Right . . . Not! 161

Effi ciency versus Equilibrium 162

Beating the Market 165

Paths 170

Sharpe Ratios and Wealth 174

1987 177

Chapter 10 The Story of Money: The Future 179

Farmers and Millers 180

Money, New and Improved 183

A General Theory of Money 185

Value and Money 189

Numeraire 191

Clearinghouses 196

Cash 197

Derivative Money 200

The End of Paper 203

Chapter 11 Cold Blood 207

Chapter 12 What Does a Risk Manager Do?—Inside VaR 213

Professional Standards 213

Front Offi ce 215

Trading Risk 217

Quants on the Job 218

Middle Office 222

Back Office 225

Middle Office Again 227

Looking Backward 228

Risk Control 230

Beyond Profi t and Loss 232

Numbers 234

The Banks of the Charles 236

Waste 238

The Banks of the Potomac 241

The Summer of My Discontent 245

Validation 247

Chapter 13 VaR of the Jungle 251

Chapter 14 The Secret History of Wall Street: 1988– 1992 255

Smile 256

Back to the Dissertation 258

Three Paths 262

An Unexpected Twist 265

Surprise! 267

Computing VaR 271

Chapter 15 Hot Blood and Thin Blood 277

Chapter 16 What Does a Risk Manager Do?— Outside VaR 283

Stress Tests 283

Trans- VaR Scenarios 287

Black Holes 289

Why Risk Managers Failed to Prevent the Financial Crisis 290

Managing Risk 296

Unspeakable Truth Number One: Risk Managers Should Make Sure Firms Fail 299

Unspeakable Truth Number Two: There’s Good Stuff beyond the VaR Limit 305

Unspeakable Truth Number Three: Risk Managers Create Risk 309

Chapter 17 The Story of Risk 313

Chapter 18 Frequency versus Degree of Belief 323

Statistical Games 324

Thorp, Black, Scholes, and Merton 329

Change of Numeraire 333

Polling 336

The Quant Revolution 341

Chapter 19 The Secret History of Wall Street: 1993– 2007 345

Where Did the Money Come From? 348

Where Did They Put the Money? 359

Where Did the Money Go? 364

Chapter 20 The Secret History of Wall Street: The 2007 Crisis and Beyond 369

Postmortem 379

A Risk Management Curriculum 387

One Hundred Useful Books 393

About the Author 401

About the Illustrator 403

Index 405

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Aaron Brown is risk manager at AQR Capital Management and the author of The Poker Face of Wall Street (Wiley), selected one of the ten best books of 2006 by BusinessWeek, and A World of Chance with Reuven and Gabrielle Brenner. In his thirty-year Wall Street career, he has been a trader, portfolio manager, head of mortgage securities, and risk manager for institutions including Citigroup and Morgan Stanley. He also served a stint as a finance professor and was among the top poker players in the world during the 1970s and 1980s. He holds degrees in applied mathematics from Harvard and in finance and statistics from the University of Chicago.

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"Wickedly original, one of the most fascinating accounts I have ever seen. A rollicking and highly opinionated read." (Risk Professional, October 2011)

“No one who reads Red-Blooded Risk: The Secret History of Wall Street will ever again regard risk management as a necessary but unproductive appendage of the financial industry. Other authors have chronicled how quantitative finance influenced investment management, but Aaron Brown has made a compelling case for a far more profound economic impact. . . If Red-Blooded Risk: The Secret History of Wall Street dealt with nothing more than the inadequacy of models used in highly important activities, it would represent a valuable contribution to financial economics. Brown’s book, however, covers a great deal more than econometric malpractice. Probably no other book offers as much insight into the process with so little resort to mathematical notation. Especially valuable are Brown’s discussions of middle-office risk management and value at risk, comparatively recent innovations that are essential to understanding modern financial institutions. Readers of Red-Blooded Risk should be prepared to have many of their assumptions challenged. Red-Blooded Risk is one of the most original and thought-provoking books reviewed in these pages in the past 20 years. No one who reads it will ever again regard risk management as a necessary but unproductive appendage of the financial industry. Other authors have chronicled how quantitative finance influenced investment management, but Aaron Brown has made a compelling case for a far more profound economic impact.”
Martin S. Fridson, CFA Institute Publications Book Reviews

“Red-Blooded Risk
mixes risk history and philosophy nimbly and provides a perspective that can be both refreshing and challenging (often on the same page). While the book is not without weaknesses, it is also brimming with original perspectives and controversial opinions. Those who work in risk management or quantitative finance will enjoy Brown’s story-telling and expert perspectives, even if they do not share his views, while non-quants will find his insights and confessions to be a useful glimpse into the psyche and ethos of an influential group of early quantitative risk takers.
Roger M. Stein, Research and Academic Relations, Moody’s Corporation, as reviewed in Quantitative Finance (August 6, 2012)

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October 05, 2011
Red-Blooded Risk

In emotional terms, thin-blooded people are motivated mainly by fear, hot-blooded people by anger and other passions—or even merely thrills—and cold-blooded people by greed. Red-blooded people feel anger, fear, and greed like anyone else, but understanding successful risk taking is a matter of calculation, not instinct. Red-blooded risk managers utilize specific mathematical techniques to turn any situation into a system with clearly delineated risks, dangers, and opportunities; optimize the risks for the best possible outcome; and arrange things so both dangers and opportunities make the maximum positive contributions.

In RED-BLOODED RISK (Wiley; October 2011; $34.95; 978-1-1180-4386-8; Hardcover; Also Available in Ebook Formats), Aaron Brown, risk manager at AQR Capital Management, offers a treatise on the theory, history, and practice of managing risk, as well as advice for the calculated risk-takers who need precise quantitative guidance that will help separate them from the rest of the pack.

The book follows several themes, which build and interconnect to provide a diverse picture of risk:

The Secret History of Wall Street: In the 1970s, young mathematicians (soon to be known as “quants”) were disillusioned by what they saw as the hypocrisy of many conventional quantitative thinkers in that they were unwilling to bet personally significant stakes on the results of their analysis. They invented a new way of looking at probability and set out to prove it in the ultimate testing ground of odds-making: Las Vegas.

Once there, the quants turned conventional wisdom about gambling on its head. People said you can't beat the house, yet the quants managed to beat blackjack and other casino games. People said you needed a lifetime to learn poker, yet the quants' aggressive mathematical tactics swept the table against the best players in the world. Then they turned to sports betting, overturning the business model and squeezing out local bookies with a global organization that matched bets without taking risk.

Armed with their theories and experience, the quants raised their sights and headed to Wall Street, determined to replicate their success. Finance was a tougher challenge than gambling, but by the mid-1990s, they had remade Wall Street as thoroughly as they had remade Las Vegas. That transformation went unnoticed by the bond salesmen and investment bankers who ran Wall Street, as well as by academics, regulators, journalists, and investors; yet these changes caused both the greatest wealth creation event in the history of the world and the financial disasters witnessed in its wake.

The Theory and Philosophy of Risk: Brown tackles the paradox of the two opposing camps of probability: frequentists, whose fundamental definition of probability rests on repeatable experiments, and Bayesians, whose foundation is subjective degree of belief, and how they have fused together in practice. He also considers the importance of Pascal’s wager and how it relates to risk, the seven principles of risk management, efficient markets, exponentials and how risk-avoiding people often use them recklessly, and the work of Harry Markowitz and John Kelly in the 1950s.  

The Story of Money: Since money is essential to managing risk, Brown examines it in depth, starting with a discussion of the idea of property and how it has led to exchange. Until someone owned something, nothing could be exchanged. He then looks how money has transformed, from the development of gambling and equal-value exchange in the Upper Paleolithic Era to the creation of paper money by the Romans to how the American colonists created low-quality money to pay for the Revolutionary War and the creation of futures contracts around 1850, when boards of trade appeared in the major cities. He then argues that derivatives are the new money in the modern economy and addresses this in the context of the fall of Lehman Brothers. Brown asks “If paper money will fade to insignificant economic importance to be replaced by derivative-like arrangements, how will this affect the nature of risk taking?”

What a Risk Manager Does: Incorporating his own experience, Brown addresses how risk management is organized within a finance-related company, from a front-office risk manager, including sales and trading, asset management, retail financial services, institutional financial services, lending and investment banking, to back office, which involves compiling what has become a huge volume of risk reports for decision makers, regulators, and investors, and the middle office, which is designed to create two information loops in the bank, focusing on information that is vital to companywide risk.

The book assesses the tools of the trade, including Value at Risk (VaR), which almost all financial risk managers use as a primary component of their processes; stress testing and scenario analysis, which concentrate on dramatic external events that could harm the firm; and the employment of mathematical techniques to identify losses that occur from unexpected combinations of events that are not individually unlikely. He also explores why risk manager failed to prevent the financial crisis and provides his list of risk “unspeakable truths,” including risk managers should make sure firms fail; there’s good stuff beyond the VaR limit; and risk managers create risk.

The Illustrated Side of Risk: Brown has teamed up with renowned manga artist Eric Kim, who has provided multiple comics, from depicting the story of money and applying VaR to surviving in the jungle to the ongoing saga of red blood (the heroine who understands risk) and the other bloods (blue, cold, hot, thin and risk manager blood sucker, among others) who fall prey to taking too much risk out of greed or arrogance or not enough out of fear.

Risk taking is not just a quantitative discipline; it is a philosophy of life. RED-BLOODED RISK demonstrates how embracing risk taking opportunities that offer a positive edge in the long run will result in expected outcomes.

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