Risk Latte - Four Questions in Finance that befuddles the mind these days?

Four Questions in Finance that befuddles the mind these days?

Rahul Bhattacharya
August 31, 2009

You may say, why four questions, there are a thousand questions that completely knocks my brain off these days. Sure.

What caused the financial crisis and market meltdown of 2008? Why did the Federal Reserve Bank and the U.S. Treasury rescue Bear Sterns and why did they leave Lehman Brothers to die? Why did so many retail investors and private banking customers in Asia lose money on a structured product called “accumulators” when the banks sold them as relatively low risk?

Why there are so many different interpretations to the term “volatility” and why volatility is itself volatile? Is volatility standard deviation? Is it simply a parameter (constant) in the Black-Scholes model or is it a variable like the underlying equity? Why can we never say with certainty whether Black-Scholes model works or not? Why economists do not understand “reverse causality” and why are they obsessed with differential calculus?

Why Ben Bernanke holds town hall meetings these days to talk about Fed’s role in bank rescue last year and why the “Bernanke Conjecture” remains the most elusive and least understood concept in modern macro-economic theory? When Ben Bernanke says “when the elephant falls down, all the grass gets crushed as well” who does he mean by “the elephant” and what does he mean by “grass”? Why Nouriel Roubini is never optimistic about the future prospects of the global economy? Why Paul Wilmott’s lectures on derivatives and his quantitative finance course are more valuable than any Ivy League Finance degree?

Why common sense and mathematics don’t go hand in hand in the financial markets? Why “a chess master, poker and blackjack devotee and top trader at Deutsche Bank AG” named Boaz Weinstein, who, according to his own claim traded complex credit derivatives using common sense and mathematics, made a loss of $1.8 billion in 2008? Why, until recently, did so many professionals and high ranking quants on Wall Street and around the world love the Gaussian Copula model for valuation of credit derivatives and why now everybody is throwing rocks at it?

Sure, these are all the questions that will make you brain dead.

But the clue to all the above, and thousands of other such questions that are swarming in your head right now, lies in understanding four questions. These four questions are quintessential to our understanding of Finance. These questions are:

  1. Why Probability and Randomness can make the world of Finance stand on its head?

  2. Why Nassim Taleb is angry with Carl Friedrich Gauss?

  3. Why is Amnesia a bigger sin in the financial markets than losing money for your clients?

  4. Why the Taylor Series expansion never truncates in the markets or on an options trading desk?

Hidden deep in these questions is the truth that governs the financial markets, that moves the wheel of economic life. To unravel the mystery of the markets and the sheer incomprehensibility of the profession called Financial Economics you need to first ask yourself these four questions.

Finding the answers to these four questions is the real challenge.

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