The Money Formula: Dodgy Finance, Pseudo-Science And How Mathematicians Took Over The Markets
Authors: Paul Wilmott and David Orrell
Publisher: John Wiley & Sons
This book starts with some unexciting sections on option pricing and value-at-risk, interspersed with familiar cautions about models being just models, not perfect representations of reality. Actuaries reading this book might jump straight to chapter 9 (of 10).
Chapter 9, entitled 'How to abuse the system', gives realistic and alarming examples of how traders can exploit model weaknesses to make themselves look good through the lens of bank bonus systems. At the same time, the model's claimed deferred benefits to other parties (better returns, lower risks) mysteriously fail to materialise. These illuminating vignettes reflect a problem in wider society: when powerful entrepreneurs flip from wealth creation that benefits everybody, to rent-seeking, which confiscates wealth from others.
With some self-righteous indignation, the book paints model exploiters as rogues who cynically unleash harmful spreadsheets for personal gain. Some might agree with this diagnosis, but I would have liked more discussion of the shades of grey. Optimising return on capital, or seeking capital efficiency, can improve competitive positioning or can be a euphemism for dangerous regulatory arbitrage, or indeed both.
Experts are sought, and paid, to make selective arguments on clients' behalf, while saying nothing that is provably false. Is it a bad thing to present a client's case in the best light? Well-paid technicians manipulate formulas or implement mathematical algorithms; can such an execution-only role still be immoral? There are useful idiots who learn by a process of trial and error that exercising judgment in a particular direction makes for happy clients or generous bonuses.
Perhaps unwittingly, all these actors erect a matrix of plausible deniability for superiors to call on when something goes wrong. Finding the real baddie in such a complex play is more difficult than the book suggests.
In a final section entitled 'Keep it simple', Wilmott and Orrell offer their prescription for a better world. They draw in bankers, quants and regulators, as well as academic mathematicians and economists. Here, Wilmott and Orrell betray their mathematical background, with proposals that are largely technical in nature. They lament bankers' excessive compensation and limited downside, but miss the origin in human power structures. It is the exercise of power that allows me to take home a multi-million-pound pay packet, yet when this is exposed as the fruits of misconduct, escape by blaming someone earning a tenth as much and throwing them under a bus.
Many of the book's solutions demand greater fortitude from those who have little power, and surrender of power by those who have it. We might need more than tweaks to a few models to set the financial world straight.