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


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:
  • Why is hedging price risk so central to the economy? And even if it is, aren't there lots of easier ways to do it? Why do we need expensive experts with advanced mathematical training?
  • Economics and financial texts agree that derivatives were invented in the second half of the 19th century in cities connected by the Mississippi River system. Are the authors all idiots?
  • The word "derivative" in the financial sense is not recorded until 1982 (although I recall it from the mid-'70s) and no one suggested they were fundamental to the economy until roughly that time. In fact, there was no concept linking the different types of contracts now included in the category: futures, options, swaps, and more complex products. The name could not have made sense until 1973, the first time anyone suggested there were securities whose prices could be derived by mathematical formulae rather than estimated from economic principles or measured by market transactions. NB: This does not mean using mathematics to estimate a fundamental or market price, or say what a price should be, but a formula that says what a price has to be for strong economic reasons.
  • The total notional value of derivatives vastly exceeds the amount of physical transactions in underlyings. Why should insurance coverage be much greater than the total value of things to be insured?
  • Derivatives caused an explosion of economic innovation when invented in the 19th century, and again when extended to financial underlyings in the 1970s.
  • Derivatives are exciting. Fortunes are made and lost in an instant, people engage in fistfights in the pits, there is constant, breathless news coverage of their ticks up and down. Crop buying and daily farm reports are dull.
  • People who trade derivatives usually have no more than cursory knowledge of the economics of the underlyings. If they are buying and selling the insurance, shouldn't they know something about the things they are insuring?
  • Why would a farmer in, say, 1870 Iowa, use a futures transaction to lock in the price for his crop? He could instead agree with a local crop buyer, who comes to his farm, to sell whatever crop he grew at whatever time it is harvested, either picked up or delivered locally, at a price to be determined either now or at delivery or in between. Weatherall has the farmer making a long and difficult journey to, say, Chicago, before he knows the size of his crop, to sign a contract to deliver a standardized commodity his crop doesn't match, in a location he cannot deliver to at reasonable expense, during a fixed time window he cannot guarantee; and commits him to daily mark-to-market payments he cannot make because (a) he's in Iowa tending his crop and (b) he doesn't have cash. On top of all this, it's not clear that fixing a price in advance reduces risk for the farmer. There is a natural hedge in that growing conditions that lead to bigger crops also lead to lower unit prices, and the reverse; also high crop prices increase the farmer's costs for the next crop while low crop prices do the reverse. In Weatherall's model, not only does the farmer have to do go to Chicago, but his opportunity to use futures has to revolutionize the economy.
  • Why would, say, a miller in 1870 Minneapolis, enter into futures contracts to buy grain to grind? As with the farmer, the futures contract specifications and delivery point do not match the exact grain he needs, the time when he needs it or the place he needs it delivered. Moreover, the price risk of grain is not clearly related to his business risk. If the price of grain goes up due to a shortage in supply, the value of milling services declines, which hurts his profit so he should hedge by going long grain. But if the price of grain goes up due to an increase in demand, the value of milling services goes up, so he should hedge by going short grain. In any event, he can do whatever price hedging he wants with fixed price contracts with suppliers or customers, and the price of grain is a minor component to his business risk, compared to things like the price of labor and fuel, or to things affecting the actual operation of his business. And even if he used futures to hedge some price risk, why would it cause extraordinary economic growth and innovation?
  • No farmers or end users of commodities were involved in the creation of futures exchanges, and both groups (especially farmers) have been generally suspicious of them and often tried to have them shut down. Neither group makes much use of exchanges, and when they do, farmers are likely to buy crops and end users are likely to sell them, exactly the opposite of Weatherall's story.
  • Derivatives have pricing models, which seem to be really important both when they work and when they don't. There's no model for the forward price at which someone will buy or sell barley, and if there were, it would be something people involved in physical production and processing would argue over, not you hire a quant to set. NB: Derivative pricing models do not predict the price of a contract, they do something more fundamental which I will describe later.
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.
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