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Published: February 28, 2006

 
 

Derivative Wisdom

Sources old and new that allow mere mortals to crack the code of cutting-edge finance.

Photograph by Steve Moors
Fifty years ago, business executives made decisions about financing their companies mostly through rules of thumb, intuition, and guesswork. They had only vague notions of how to analyze even the most basic financial decisions: for example, whether to fund a growing business by issuing new stock or by borrowing in the bond market. There were no dependable frames of reference for dealing with such emerging risks and uncertainties as energy supply shocks, double-digit inflation, and volatile interest and exchange rates.

Nearly everything is different today. Corporate executives and individual investors have sophisticated tools for measuring and assessing risk and return. New vehicles such as index funds have become common and taken much of the guesswork out of personal investing. New financial instruments such as futures, options, swaps, and derivatives allow far more risk management than before. Executives and investors can choose the financial risks they want to assume and, in some cases, mitigate or hedge the ones they can’t avoid. One humble contemporary example is the adjustable-rate mortgage, with an interest rate that fluctuates in line with market rates and a cap on how far the rate can rise: A more complex example is the swap option, which allows a company that has issued floating-rate debt to limit its losses if interest rates rise, while still benefiting if they fall. These kinds of financial instruments, commonplace today, were unthinkable in the 1960s because the financial theory and practice of the times were incapable of valuing them.

Modern finance has also had a beneficent effect on the larger economy. Former Federal Reserve Chairman Alan Greenspan said as much in a speech to the American Bankers Association annual convention in October 2004: “Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” He noted that in recent years the largest corporate defaults in history (Enron, WorldCom) and the largest sovereign default in history (Argentina) occurred without significantly threatening the solvency of any major bank or investment house.

It took a revolution in the field of finance to produce the theories and techniques that make possible today’s more sophisticated markets. This revolution started in the 1950s inside the heads of a few dozen economists, mathematicians, statisticians, and physicists working at universities and consulting firms. Modern quantitative finance came of age between the 1970s and 1990s, but is only reaching full maturity now. With the exception of the computer and the Internet, no modern development has affected business more powerfully.

Thinking outside the Basket
Appreciating the nature of this revolution isn’t easy, for several reasons. First, the math is daunting. Anyone who hasn’t recently ventured beyond college-level calculus will quickly get lost in any of the academic papers on the subject and in many of the books that purport to explain it. Second, the history of the revolution, while fascinating, is tangled. Most of the important insights and advances were made by teams of academics and practitioners, sometimes working together and sometimes working independently, and each historian tends to focus on certain individuals at the expense of others. Third, many of the most important insights of modern finance, stated baldly, seem so simplistic or obvious as to be trivial.

Two recent books, Fischer Black and the Revolutionary Idea of Finance, by Perry Mehrling, and My Life as a Quant: Reflections on Physics and Finance, by Emanuel Derman, provide insightful, on-the-ground accounts of the intellectual battles that raged during the revolution. But to understand the context in which those battles took place, it’s best to start with a classic by the eminent business historian Peter L. Bernstein: Against the Gods: The Remarkable Story of Risk (1996). Early in his book, Mr. Bernstein sets the stage:

 
 
 
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Modern Finance Resources:
Works mentioned in this review.

  1. Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (John Wiley & Sons, 1996), 400 pages, $19.95
  2. Peter L. Bernstein, Capital Ideas: The Improbable Origins of Modern Wall Street (Free Press, 1992; John Wiley & Sons, 2005), 352 pages, $16.95
  3. Emanuel Derman, My Life as a Quant: Reflections on Physics and Finance (John Wiley & Sons, 2004), 304 pages, $29.95
  4. Perry Mehrling, Fischer Black and the Revolutionary Idea of Finance (John Wiley & Sons, 2005), 392 pages, $29.95
  5. Hersh Shefrin, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing (Harvard Business School Press, 2000), 378 pages, $44.50
  6. Lauren Aguirre et al., “Trillion Dollar Bet,” Web site based on the February 8, 2000, WGBH Nova documentary: Click here. 
  7. Wikipedia, the free online encyclopedia edited by its readers: Click here.