In The New York Review of Books for June 24th, Paul Volcker has a cautionary piece about the imbalances, deficits, and risks of our fiscal situation. The essay is called “The Time We Have Is Growing Short.” Five years ago, Volcker writes, he saw the need for fundamental changes but saw no public resolve for doing anything either on the part of the public or the politicians. At that time, he predicted that the only way reform was going to occur was if there was a crisis. Little did he know how large a crisis was ahead.
Volcker writes that he did not anticipate the enormity of the crisis in part because “innovations” such as credit default swaps and CDOs had not existed in his day. Nor did the fancy computer models exist that were developed to devise, build, and evaluate the risks of those innovations. Those models assume that financial markets followed laws similar to those of the hard sciences. Volcker sees this as a big mistake: “One basic flaw running through much of the recent financial innovation,” he writes, “is that the thinking embedded in mathematics and physics could be directly adapted to markets.” But financial markets, he points out, do not behave according to changes in natural forces; rather they are human systems and are prone to herd behavior and wide swings in emotions. They are also subject to political influences and various uncertainties.
The quantification of the financial markets in sophisticated computer modeling was not a dominant part of the financial world that Volcker inhabited in the Federal Reserve of the fifties through the eighties. Yet the seeds of change were certainly there. They were planted in the early seventies when a somewhat coincidental rise in market volatility, computation, and financial modeling began to transform the financial industry.
Many factors contributed to the growing volatility of the markets in the early seventies. After the dollar was cut free from the gold standard in 1971, volatility invaded the foreign exchange markets. Oil prices, which had remained stable for decades, exploded. And interest rates and commodity prices saw levels of volatility that would have been unthinkable in the three previous decades. Financial deregulation and inflation contributed to the mix as well.
As Peter Bernstein wrote in his history of risk, Against the Gods (1996), the rising market volatility of the 70s and 80s produced a new demand for risk management. In the face of all this volatility and uncertainty, Wall Street saw its traditional investing strategies as inconsistent and unpredictable. They were old-fashioned, the operating methods, as one senior Wells Fargo Bank officer wrote at the time, of a “cottage industry.” It seemed something new—some more "modern" innovation—was being called for.
That innovation arose from two sources, both of which burst upon the scene in 1973. That was also the year when a new exchange for managing risk, in this case by buying and selling stock options, was opening up. Innovation both in computers and in financial models were jointly destined to create dramatic changes in the financial markets. The extraordinary power of computers greatly expanded the market’s ability to manipulate data and to devise and manage complex strategies and products. Models, on the other hand, seemed to offer some new and supercomplex way to avoid at least some of the new uncertainty investors faced. It was the beginning of the age of modern risk management.
The 1973 series of events incorporated all the major elements o f the changes to come:
· In April 1973, the Chicago Board Options Exchange opened. The new exchange provided traders with an established process for trading stock options, including standardized contracts and market-makers who would buy and sell on demand, thus providing liquidity to the market. This was seen as a way to manage the risks involved in the stock market itself.
· The following month, an article appeared in The Journal of Political Economy explaining for the first time the Black-Scholes-Merton method for valuing options. This model, expressed in complex algebra, used four basic elements to calculate the value of an option and in so doing included a quantitative method for determining volatility.
· At the same time, Texas Instruments introduced its SR-10 handheld electronic calculator. Within months TI was running large ads in The Wall Street Journal pitching new possibilities to traders, “Now you can find the Black-Scholes value using our calculator.”
It didn’t take long for options traders to start using technical expressions from the Black-Scholes-Merton model to calculate the risks of their options. Armed with their new handheld computers, traders on the floor of the Chicago Board Options Exchange could run a formula to quantify risk and automatically calculate the value of a given stock option. As Bernstein points out, a new era had begun in the world of risk management.
What characterized this new era of risk management? Clearly it had much to do with the power of computers. Clearly it had much to do with complex mathematical models for expressing and predicting risk. And clearly it had much to do with an inordinate belief in the efficacy of those models and in the power of those computers to escape uncertainty by “managing” risk.
But how modern, how advanced, was it all? Toward the end of Against the Gods, Peter Bernstein offers a stark comparison between those who trust in complex calculations today and the ancient Greeks: “Those who live only by the numbers,” he observes, “may find that the computer has simply replaced the oracles to whom people resorted in ancient times for guidance in risk management and decision-making.”
So it seems that, as long as belief in the calculations computer models prevails in the markets, we not much better off than those who journeyed to Delphi long ago to worship Apollo and consulted the oracle therein regarding their fates.
Volcker writes that he did not anticipate the enormity of the crisis in part because “innovations” such as credit default swaps and CDOs had not existed in his day. Nor did the fancy computer models exist that were developed to devise, build, and evaluate the risks of those innovations. Those models assume that financial markets followed laws similar to those of the hard sciences. Volcker sees this as a big mistake: “One basic flaw running through much of the recent financial innovation,” he writes, “is that the thinking embedded in mathematics and physics could be directly adapted to markets.” But financial markets, he points out, do not behave according to changes in natural forces; rather they are human systems and are prone to herd behavior and wide swings in emotions. They are also subject to political influences and various uncertainties.
The quantification of the financial markets in sophisticated computer modeling was not a dominant part of the financial world that Volcker inhabited in the Federal Reserve of the fifties through the eighties. Yet the seeds of change were certainly there. They were planted in the early seventies when a somewhat coincidental rise in market volatility, computation, and financial modeling began to transform the financial industry.
Many factors contributed to the growing volatility of the markets in the early seventies. After the dollar was cut free from the gold standard in 1971, volatility invaded the foreign exchange markets. Oil prices, which had remained stable for decades, exploded. And interest rates and commodity prices saw levels of volatility that would have been unthinkable in the three previous decades. Financial deregulation and inflation contributed to the mix as well.
As Peter Bernstein wrote in his history of risk, Against the Gods (1996), the rising market volatility of the 70s and 80s produced a new demand for risk management. In the face of all this volatility and uncertainty, Wall Street saw its traditional investing strategies as inconsistent and unpredictable. They were old-fashioned, the operating methods, as one senior Wells Fargo Bank officer wrote at the time, of a “cottage industry.” It seemed something new—some more "modern" innovation—was being called for.
That innovation arose from two sources, both of which burst upon the scene in 1973. That was also the year when a new exchange for managing risk, in this case by buying and selling stock options, was opening up. Innovation both in computers and in financial models were jointly destined to create dramatic changes in the financial markets. The extraordinary power of computers greatly expanded the market’s ability to manipulate data and to devise and manage complex strategies and products. Models, on the other hand, seemed to offer some new and supercomplex way to avoid at least some of the new uncertainty investors faced. It was the beginning of the age of modern risk management.
The 1973 series of events incorporated all the major elements o f the changes to come:
· In April 1973, the Chicago Board Options Exchange opened. The new exchange provided traders with an established process for trading stock options, including standardized contracts and market-makers who would buy and sell on demand, thus providing liquidity to the market. This was seen as a way to manage the risks involved in the stock market itself.
· The following month, an article appeared in The Journal of Political Economy explaining for the first time the Black-Scholes-Merton method for valuing options. This model, expressed in complex algebra, used four basic elements to calculate the value of an option and in so doing included a quantitative method for determining volatility.
· At the same time, Texas Instruments introduced its SR-10 handheld electronic calculator. Within months TI was running large ads in The Wall Street Journal pitching new possibilities to traders, “Now you can find the Black-Scholes value using our calculator.”
It didn’t take long for options traders to start using technical expressions from the Black-Scholes-Merton model to calculate the risks of their options. Armed with their new handheld computers, traders on the floor of the Chicago Board Options Exchange could run a formula to quantify risk and automatically calculate the value of a given stock option. As Bernstein points out, a new era had begun in the world of risk management.
What characterized this new era of risk management? Clearly it had much to do with the power of computers. Clearly it had much to do with complex mathematical models for expressing and predicting risk. And clearly it had much to do with an inordinate belief in the efficacy of those models and in the power of those computers to escape uncertainty by “managing” risk.
But how modern, how advanced, was it all? Toward the end of Against the Gods, Peter Bernstein offers a stark comparison between those who trust in complex calculations today and the ancient Greeks: “Those who live only by the numbers,” he observes, “may find that the computer has simply replaced the oracles to whom people resorted in ancient times for guidance in risk management and decision-making.”
So it seems that, as long as belief in the calculations computer models prevails in the markets, we not much better off than those who journeyed to Delphi long ago to worship Apollo and consulted the oracle therein regarding their fates.
RSS Feed