The Money Formula

Dodgy Finance, Pseudo Science, and How Mathematicians Took Over the Markets

Paul Wilmott, David Orrell

• Publisher: Wiley
• Year: 2017
• Print ISBN: 9781119358619
• eBook ISBN: 9781119358688
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Explore the deadly elegance of finance's hidden powerhouse

The Money Formula takes you inside the engine room of the global economy to explore the little-understood world of quantitative finance, and show how the future of our economy rests on the backs of this all-but-impenetrable industry. Written not from a post-crisis perspective – but from a preventative point of view – this book traces the development of financial derivatives from bonds to credit default swaps, and shows how mathematical formulas went beyond pricing to expand their use to the point where they dwarfed the real economy. You'll learn how the deadly allure of their ice-cold beauty has misled generations of economists and investors, and how continued reliance on these formulas can either assist future economic development, or send the global economy into the financial equivalent of a cardiac arrest.

Rather than rehash tales of post-crisis fallout, this book focuses on preventing the next one. By exploring the heart of the shadow economy, you'll be better prepared to ride the rough waves of finance into the turbulent future.

• Delve into one of the world's least-understood but highest-impact industries
• Understand the key principles of quantitative finance and the evolution of the field
• Learn what quantitative finance has become, and how it affects us all
• Discover how the industry's next steps dictate the economy's future

How do you create a quadrillion dollars out of nothing, blow it away and leave a hole so large that even years of "quantitative easing" can't fill it – and then go back to doing the same thing? Even amidst global recovery, the financial system still has the potential to seize up at any moment. The Money Formula explores the how and why of financial disaster, what must happen to prevent the next one.

CHAPTER 1
Early Models

“Nature, and Nature's Laws lay hid in Night.

God said, Let Newton be! And All was Light.”

—Alexander Pope

“Beelzebub begat Law

Law begat the Mississippi

The Mississippi begat the System (etc.)”

—Het Groote Tafereel der Dwaasheid (The Great Mirror of Folly)

The mathematical models used by quants are based on ideas and concepts developed by generations of economists. They in turn were heavily influenced by physics. But is it really possible to model the markets as a kind of physical system, or is quantitative finance more like a set of mathematical tricks for betting on markets? This chapter traces the development of economics; looks at the basic assumptions such as equilibrium and rationality that have shaped both economics and finance; and considers the dual nature of quantitative finance, as exemplified by two men – John Law and Isaac Newton.

In 1705, Scotland was contemplating union with its neighbor England. The English economy was riding high, and Scotland's leaders thought this might be an opportune moment for a merger. However, not everyone thought hooking up was a good idea. One person who argued against it was the banker, gambler, and social climber John Law. He went so far as to propose an entirely new monetary system for Scotland, which he claimed would go beyond the English system and in a stroke solve his country's monetary problems while boosting trade.

Part of England's success was due to its newly created central bank, the Bank of England, and efficiencies created by the introduction of bank notes. However, Law thought he could do better. According to him, the problem with this new English paper money was not that it was too radical, but that it was not radical enough, since it was still exchangeable for gold. Its supply was therefore determined not by the needs of the economy, but by the quantity of precious metal that happened to be in circulation at the time. In his text Money and Trade Consider'd with a Proposal for Supplying the Nation with Money, he argued that Scotland needed a central bank of its own, that issued its own paper currency, but one that was backed only by the state rather than by precious metal. After all, according to this son of an Edinburgh goldsmith, money was just a “Sign of Transmission,” like a casino chip, and not a store of real wealth.

The stakes for Law were greater even than the questions of Scottish independence or the meaning of monetary value. Ten years earlier, he had been charged with murder following a duel in London. After being imprisoned, he soon escaped and fled to Amsterdam. For several years he had toured around Europe, supporting himself and his young family by gambling (a trained mathematician, he claimed to have a system), before returning to Scotland. But if that country joined with England, he would have to leave or find himself back in jail.

This time, the dice did not fall in Law's favor. His radical monetary proposal was rejected by parliament, the union with England went ahead, and Law was again on the run from the law.

He set himself up in Paris, playing cards at all the fashionable salons. His system was extremely successful – so much so that he drew the attention of the Chief of Police, M. d'Argenson, who expelled him from the city. Again he hit the road, touring through Germany and Italy in a coach, amassing considerable wealth from his winnings; his prowess at gambling becoming something of a legend. When the “Sun King” Louis XIV died, leaving his country with a massive debt (incurred from wars and the construction of his palace at Versailles) and a bankrupt treasury, Law saw an opportunity and returned to France. There was a shortage of money, and he had the answer. He quickly won over the regent, Philippe d'Orléans, who took a chance on the Scotsman and appointed him as Controller General of Finances – perhaps with the hope that his “system” would work as well for the economy as it did at cards.

Monetary Alchemy

Law's plan for the country – and he did not lack ambition – consisted of two parts. The first was to set up a state bank financed initially by himself, the Banque Générale, that would issue paper money redeemable in gold or silver. The bank was hugely successful, and its notes soon attracted a premium just for their convenience over coins. The second, which followed two years later, was to establish a company called the Mississippi Company, that would be granted a royal monopoly on trade with Louisiana – a vast region that encompassed the entire Mississippi River Valley.

Neither idea was new. The Bank of England and the Bank of Amsterdam already issued paper receipts for gold that could be traded as money. The Mississippi Company was modeled on the East India Companies of Britain and Holland. Law's brilliant idea was to connect the two, and unleash the alchemical power of paper money. Paper shares in the company could be bought using the paper money produced by the bank, in what seemed like a kind of perpetual-motion machine. In 1718 the bank was nationalized, becoming the Banque Royale; with this royal approval obtained, it was then announced that its notes would no longer be redeemable for precious metal.

Money was finally untethered from metal, its value determined instead by the authority of the French crown. A positive consequence was that the state could print as much money as it needed to satisfy the ravenous public appetite for shares, as people flocked from all over the country and abroad to take part in the economic miracle of Law's system. With all this money circulating around at a ferocious rate, the economy boomed. The word “millionaire” came into use for the first time. In 1719 alone, the Company share price vaulted from 500 livres to over 10,000 livres. The dropping of the dead-weight connection to metal also released any restraints on Law's bounding ambitions. In no time he was arranging for the Company to buy the national debt, and have the right to collect taxes. This required issuing many more shares, and many more paper notes to buy them with. Which is when Law's system started to reveal its flaws.

While Law was certainly correct that money serves as a “Sign of Transmission,” its value also depends on the confidence and trust of the community, and he had made the same mistake that he had made as a gambler in Paris, which was to fail to arrange buy-in from all the relevant players. Then it was the Chief of Police, d'Argenson, now it was the business and banking community (which included d'Argenson, who had become a prominent businessman). Rumors began to circulate that Louisiana was not quite the wealth generator it was cracked up to be, and Mississippi Company shareholders began to suspect they were being sold down the river.

The trip down was just as brief and thrilling as the way up. Suffice to say that, as the Company's share price drained away, and the value of the bank's paper notes approached zero, Law was again drummed out of Paris, and the country, and ended up near destitute in Venice. The story ought to serve as a cautionary tale for present-day central bankers. Oh, except that these days no bankers, central or otherwise, ever end up destitute.

Gold Standard

While Law was introducing the French to the benefits, perils, and general excitement of fiat currencies and financial innovation, Isaac Newton was serving as Warden of the Mint in England. Newton is of course best known for his famous contributions to physics, but he worked at the Mint from 1696 until his death in 1727. It is safe to say that his approach to finance was the opposite of Law's. At exactly the same time that Law was arranging to delink the livre from gold or silver, Newton was putting the pound on the gold standard, where it would remain for the next couple of hundred years.¹ While Law was issuing what some considered to be fake money, Newton was sending counterfeiters to their death. One wonders what he would have said about the situation in France, from his position at the Tower of London. Perhaps he felt some sympathy with Law's fall from grace; he did manage to lose £20,000 himself (over £2 million in today's money) on his investment in the South Sea Company, the British version of the Mississippi Company.

The two certainly had completely different personalities. Here is a portrait of the young John Law by journalist John Flynn: “He got access to the smartest circles. He was a young man of education and culture, handsome, quick-witted, a good athlete excelling at tennis, a graceful dancer, and a redoubtable talker. He spent his mornings in the city, where he got a reputation for skill in speculating in government paper. He passed his afternoons in the parks, his evenings at the opera or theater, and the later hours at the routs, balls, masquerades, and gaming houses. He played for high stakes and won large sums. He was a man with a system. Had he lived in our time he would have been in Wall Street with an infallible formula for beating the market.”² Perhaps he would have launched a hedge fund, or penned a bestseller about his “system.”

Isaac Newton, in contrast, was a decidedly more solitary type. As a child, he showed great talent at making models, such as a working wind...

Table of contents

• Cover
• Title Page
• Copyright
• Acknowledgements
• About the Authors
• Introduction
• Chapter 1 Early Models
• Chapter 2 Going Random
• Chapter 3 Risk Management
• Chapter 4 Market Makers
• Chapter 5 Deriving Derivatives
• Chapter 6 What Quants Do
• Chapter 7 The Rewrite
• Chapter 8 No Laws, Only Toys
• Chapter 9 How to Abuse the System
• Chapter 10 Systemic Threat
• Epilogue: Keep it Simple
• Bibliography
• Index
• EULA