'The Physics of Wall Street': The Most Arrogant Book in the World? Part 5

By Aaron Brown  JAN 14, 2013 9:00 AM

Derivative fiction.


Editor's note: The following column is the fifth part of an ongoing series of articles by Aaron Brown examining the claims made in The Physics of Wall Street: A Brief History of Predicting the Unpredictable, a new book by James Owen Weatherall.

Click here to read Part 1.
Click here to read Part 2. 
Click here to read Part 3.
Click here to read Part 4.

James Weatherall’s recent book, The Physics of Wall Street does a remarkably clear job of expounding the errors many quantitatively-trained people make when first encountering finance. I’m using the book to explain these common errors.

Over the last 50 years, the global financial system has been completely reengineered, a process Weatherall credits to physicists. If you had to pick a single change at the heart of this it would be the growth of derivatives at the expense of national-government-issued credit money with value ultimately tied to gold. So it’s remarkable that Weatherall’s explanation of what a derivative is and why it matters is not only a complete fiction, and not even fiction that makes sense.

Derivatives are as central to the modern financial revolution as steam power was to the Industrial Revolution. To a practitioner or historian, The Physics of Wall Street reads like a book by a recent seminary graduate who skimmed Max Weber’s The Protestant Ethic and the Spirit of Capitalism and concluded that priests designed the Industrial Revolution. A friend mentions that steam seems to have something to do with it. Our inexperienced author thinks for a nanosecond and decides without steam all the coal he sees delivered to factories would bury the buildings. “It’s just like burning garbage in Mesopotamian times,” he writes, and makes up a story about a priestess Iltani hiring the sons of Siniddianam to burn her garbage so it doesn’t bury the ziggarut.

Believe it or not, that is precisely Weatherall’s account of derivatives. He claims they have been around for over 4,000 years and cites a story of priestess Iltani agreeing on a fixed-price forward delivery contract with the sons of Siniddianam. The reader might be forgiven for thinking Weatherall has spent too much time playing Assassin's Creed.  In fact, the names come from an ancient clay table that records not a forward purchase transaction but a loan of barley to be repaid in barley. Ironically, Weatherall misrepresents the agreement to make it correspond more closely to his misconception of a derivative, but the actual transaction is closer to what a derivative really is. Weatherall claims the purpose of derivatives is to help producers and end users of commodities or financial instruments protect themselves against price risk.

Let’s think of a few things Weatherall’s made-up theory does not explain:
To be fair, no model is perfect. We have to set the things Weatherall’s model doesn’t explain against the things it does explain. Ummm…that would be nothing. Yet the guy had the arrogance to write a book about derivatives (among other things) and claim that he knows physicists invented them, even if he has no idea what they are.

Next week I’ll explain what derivatives really are, and why they matter.
No positions in stocks mentioned.

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