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Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?

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Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?

Pablo Triana, Nassim Nicholas Taleb (Foreword by)

ISBN: 978-0-470-40675-5 May 2009 400 Pages

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LECTURING BIRDS ON FLYING

For the past few decades, the financial 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 financial insiders (traders, risk managers, executives) and outsiders (academics, journalists, regulators, the public) consistently demonstrated a willingness to treat quantifications as gospel? Nassim Taleb first addressed the conflicts between theoretical and real finance in his technical treatise on options, Dynamic Hedging. Now, in Lecturing Birds on Flying, Pablo Triana offers a powerful indictment on the trustworthiness of financial theory, explaining—in jargon-free plain English—how malfunctions in these quantitative machines have wreaked havoc in our real world.

Triana first analyzes the fundamental question of whether financial 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. The author then examines the sources of origin of many prevalent theories and mathematical dictums. He details how the field of financial economics evolved from a descriptive discipline to an abstract one dedicated to technically concocting professors' own versions of how such a world should work. He goes on to explain how Wall Street and other financial centers became eager employers of scientists, and how scientists became eager employees of financial firms. Triana concludes with an in-depth discussion of the most significant 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 financial power of those who are completely unchained to the iron ball of classroom-obtained qualifications.

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 •

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 •

Chapter 9 An Unhealthy Yearning for Precision 267

• Dangerous voluntary enslavement • Let freedom ring • Normality can kill you • A VIXing issue • Protect those derivatives •

Chapter 10 We Need Fat Tony 297

Finale Should The Nobel Prize in Economics Be Eliminated? 305

Notes 319

Acknowledgments 335

About the Author 337

Index 339

"Points to the over-reliance on financial models and quantitative techniques as what ultimately brought down the financial markets. Sure, many of us feel that we have heard enough on this topic-do we really need another book about the financial mess and how it all began? Yes, we do. . . Triana's impressive knowledge and experience allows him to dig deeper and go beyond the mere musings of his published peers."
—Risk Management Magazine

"Readers of this book may make quite a lot of noise. . . Some will cheer out loud; others will yelp as cherished beliefs are torn into. At times, the book is deliberately incendiary. Triana is trying to stimulate debate. . . On the whole, this is a good read."
—The Financial Times, July 23rd 2009

"...calls for a return to "good old fashioned commonsense decision making"."
—Daily Express, June 4th 2009

"This book explains how it is that theoretical finance can fail dramatically in the real world."
—Finanace & Management Faculty, June 2009

"The book is fizzing with ideas"
—The Economist, June 29th 2009

" Triana’s book will ruffle a lot of feathers, but it also will make many readers think hard."
—BizEd

"A deeply unsettling insider account of how bogus mathematics overtook finance and was a key contributor to the financial collapse of 2008-2009 . . . With deep insight, Triana deconstructs the "pillars" of mathematical finance . . . Like Nassim Taleb, celebrated author of The Black Swan (2007), Triana is calling for major surgical reform of such business schools' curricula. An important addition to our deeper understanding of how finance must be reformed."
—Hazel Henderson, Ethical Markets

"Should the Nobel Prize for economics be abolished? That is one of the suggestions in Pablo Triana's provocative book "Lecturing Birds on Flying: Can Mathematical Theories Destroy the Markets?" . . . As Nassim Nicholas Taleb writes in his witty introduction to the book, giving someone the wrong map is worse than giving them no map at all. . . a good read. Some may find the elaborate prose closer to Cervantes than to, say, Nobel Prize winner Robert Merton -- annoying. But perhaps Cervantes is the right writer to emulate when tilting at windmills. "
—LA Times

"The highlight of Triana's book is his valuable insights into the problems with mathematical economic models, which make his argument quite forceful."
—Shanghaidaily.com