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Published: February 28, 2006

 
 

Derivative Wisdom

The road of quantitative finance in the marketplace has not always been straight and broad, and it is littered with some spectacular financial wrecks. The stock market crash of 1987, for instance, revealed that newly minted securities such as stock-index options and novel trading schemes like portfolio insurance (in which an investment portfolio is programmed to sell securities automatically when prices decline) could lead to fast and violent price declines. In the mid-1990s, large corporations like Gibson Greetings, Metallgesellschaft, and Procter & Gamble lost huge sums by making unwise financial bets using derivative securities they didn’t understand. In 1998, Long-Term Capital Management — a high-tech hedge fund whose founders included Robert Merton and Myron Scholes — pushed risk too far in the search for return. They wiped out their own fortunes and those of many others, ultimately requiring a multibillion-dollar bailout. (Fischer Black, interestingly, declined an offer to join in the venture because he foresaw the risks.) As Financial Times columnist James Morgan puts it, “A derivative is like a razor. You can use it to shave yourself…or you can use it to commit suicide.”

As is the case with many groups of innovators, the personalities of the protagonists played a role in defining their reach, their grasp, and their influence. You can see that clearly in one additional resource: a Nova documentary called “Trillion Dollar Bet.” Originally broadcast in February 2000, this program has subsequently been adapted into a Web site, with transcripts and images available. There you can see the formula firsthand and explore some of the mathematics involved in parsing it — not that this will necessarily make you rich. Another great Web resource is the free, user-adaptable encyclopedia Wikipedia, which has useful, up-to-date entries on many of the concepts and individuals mentioned in this review. It takes a whole community of knowledgeable acolytes, all correcting one another, to make these concepts comprehensible.

Could the improved understanding of financial risks created by the revolution of modern finance, and the financial tools and techniques that grew out of it, have enabled the world’s markets to better survive upheavals? In fact, the last two decades have been a time of remarkable economic and financial stability: There have been only two recessions in the U.S. since 1982, both quite mild by historic standards, compared with five more serious ones in the preceding 23 years. And world financial markets have absorbed a long list of crises over the last decade without freezing up or crashing. These crises included the stock market bubble collapse of 2000, the terrorist attacks of September 11, 2001, and more recent natural disasters such as the Asian tsunami and Hurricane Katrina. In an earlier time, when markets were less flexible and robust and when our appreciation and quantification of risk were more primitive, it’s easy to imagine such events causing panics and market failures.

The theories of modern finance themselves tell us that we can’t know the answer for certain. But the evidence to date suggests that modern finance has changed the world for the better.

Reprint No. 06111

Author Profile:


Rob Norton (rob@robnorton.com) is a writer and consultant in New York. A former executive editor of Fortune magazine, he is the editor of CFO Thought Leaders: Advancing the Frontiers of Finance (strategy+business Books, 2005).
 
 
 
 
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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.