The Physics of Wall Street.

Friday, January 04, 2013

James Weatherall talks about why many of the mathematicians and software engineers on Wall Street failed when their abstractions turned ugly in practice, and looks at a special breed of physicists with a deep history of revolutionizing finance. He shows how physicists successfully brought their science to bear on some of the thorniest problems in economics, from options pricing to bubbles in The Physics of Wall Street: A Brief History of Predicting the Unpredictable.



James Weatherall

Comments [18]


Instead of listening to economically-ignorant scientists, this will give you a good understanding of why we have [intentional] boom-and-bust business cycles.

Jan. 04 2013 03:45 PM

MEMO to this James Weatherall:

“It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.”

Though economics—unlike physics and chemistry—is a social, rather than a natural science, there are economic laws. You can ignore economic laws, but economic laws won't ignore you.

Jan. 04 2013 03:42 PM
JL from Queens

Good discussion, it's hard to explain many of these concepts in a brief and wide-ranging format like a radio show.
However, I think that what comes across to some degree supports the fallacy that mathematical models, and particularly their shortcomings, are responsible for market crashes or bad economic events.

Quant hedge funds notwithstanding, the majority of the technical expertise in the finance industry is dedicated to valuing securities (primarily derivatives), as opposed to predicting. Increased precision in valuation allows markets for increasingly exotic securities to develop and grow. This is where the real money is made, not in prediction (aka arbing out inefficiencies), which is contrary to most people's conception of how money is made on wall street.

Derivatives have existed, as Weatherall notes, long before the existence of the mathematics to accurately value them. One of his examples, the CDO (and its many cousins) is illustrative. These structures were created even before there were accepted ways to model their price behavior and risk. The development of widely accepted valuation technology allowed them to grow more quickly from a small niche to a huge market. But the willingness of all market participants to accept models that were widely known to be inadequate at expressing the true risks is indicative that these instruments were going to be traded one way or the other, and the quants were not driving the process. The profitability of mortgages drove the creation of the market, and dictated the terms of the modeling, not the other way around.

Jan. 04 2013 12:53 PM

1. The fiscal cliff was never much of a cliff — at least not for 1 January.

2. Congress and Obama behaved as expected — putting things off until the last minute and then cobbling together a partial solution.

Jan. 04 2013 12:40 PM
MichealC from Manhattan

Better we move away from the PERCEPTION that Wall streets numbers game matters... let them play in a sandbox that isolates all this from the real economy and that is what a strong social service state gives , health care , housing and food all in abundance should be provided for so that this does not matter

Jan. 04 2013 12:40 PM
Amy from Manhattan

Aren't black swan-type events in the markets themselves--like a multi-billion-dollar Ponzi scheme or a catastrophic financial collapse--more relevant than natural disasters?

Jan. 04 2013 12:39 PM
Gordon from QUEENS

All chasing ever increasing "numbers" stored in virtual accounts. Zero means nothing "0" except when you gather six or more of them and put a prime number in front of them

as long as there are human beings there will never be an end to wealth , it's the distribution that is the problem

Jan. 04 2013 12:36 PM
Mark G from NYC

This completely misstates Random Walk Theory. Stock PRICES are not random the [next] CHANGE in a stock's price -- up or down -- is random. If stock prices were random value investors (like Warren Buffet) couldn't make money.

Further, the "zero sum" statement is also FALSE. There are are LOTS of reasons why someone might sell a stock she thought might rise. Most obvious to buy a stock that she expects to rise at a faster rate. Others might be to cover previous short positions, because the person or algorithm intends to make money on volatility or changes in it, etc.

Many of your guest's contentions -- including describing Black Swan Theory -- or just plain wrong.

Jan. 04 2013 12:36 PM
Michael from Greenpoint

Can we please move AWAY from Wall Street and a casino economy?

Jan. 04 2013 12:36 PM
John A

Important question here I think is: 'Are innocents exploited for greed in a business?'. I'd say to that "all the time". Author does sound like a real innocent, though it's a first impression.

Jan. 04 2013 12:31 PM
Andrew from New York

For some insight into the role of financial modelling in the 2008 debacle, read this, from someone who has a deep understanding of the issues:

"[The ratings agencies] did not accidentally have bad underlying models. The bankers packaging and selling these deals, which amongst themselves they called sacks of ..., did not blithely believe in their safety because of those ratings. Rather, the entire industry crucially depended on the false models."

Jan. 04 2013 12:29 PM
Micheal C from Manhattan

Large scale modern economics and quantum physics share a lot in common in that when you drill down to the smallest levels ... there really is no "there" there. Economics is based on valuation which not unlike the waves which are thought to underpin physical phenomena we perceive, are fleeting and not solid at all, but only subject to confluences of perception that assume the "there"... much like the uncertainty principle. Wealth is a reflection of the perception of needs and wants and itself ephemeral. Was not the tulip crash not unlike the cat in the box that perception determines is dead or not on observation?

Jan. 04 2013 12:21 PM
John A

The previous commenter mentions several times evaluation. Is that not the philosophic break, that money is becoming increasingly virtual and not physical, whereas what money is intended to do is to feed and house people in a very physical world.

Jan. 04 2013 12:21 PM
fuva from harlemworld

Haven't "geeks bearing formulas" introduced the complexity in Wall Street that has been behind all recent failures and that make it almost impossible to regulate?

Jan. 04 2013 12:17 PM

Weatherall just noted that among the things that have changed in the market are the models themselves. This seems to suggest that the things intended to follow, describe, and predict market behavior are themselves affecting market behavior (which may be obvious, I guess).

Jan. 04 2013 12:16 PM
AM from New York

Physicists are concerned with more than just prediction. They are also concerned with evaluation. (e.g. How uniform is the 3-degree background radiation today?) Some even do evaluation on Wall Street, (e.g. What meaningful return for the day did a total fund receive on IBM when IBM was traded multiple times within the day but all settlement occurred at the close and the weighted sum of all component returns equals the fund’s return for the day?)

Please try to get your guest to address issues beyond prediction.

The mathematically difficult area of evaluation on Wall Street is never addressed in popular discussions, often totally downplayed because of a total lack of appreciation for the challenges involved. Though crucial both to understanding the investment process and to subsequent prediction, evaluation is extremely more conceptually (not just practically) difficult than commonly believed. Is your guest knowledgeable enough to break the silence on the significant level of conceptual difficulty involved in evaluation and how it is being addressed well or poorly by physicists on Wall Street and the dangers these conceptual challenges involve?

Jan. 04 2013 11:52 AM
John A

I'd appreciate stories of the most humanist(ic?) of these people. It's really starting to look like computer games on a grand scale.
There is also the problem of the emergent properties of this system. A future crash is likely being constructed, unwittingly of course.
Finally, this is more of the same, of gambling and now gaming taking precedence over classic investing.

Jan. 04 2013 11:08 AM
rh from queens

1. can you comment on the relationship between Benford's Law and the Periodic table? (John Barrow's lecture?) and FTR, i believe that most members of Congress happen to use a system/language of math commonly referred to 'billable hours'.

2. are you familiar with any of Andrew Lo's work (from MIT). He's working on this idea as well, and has also worked in Washington.

Jan. 04 2013 10:37 AM

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