Perfect market model that could not stand reality

Inventing Money
June 16, 2000

In September 1998, the world's largest single financial rescue package was announced. Not to save Russia, which had just gone bankrupt. Not to save a massive industrial company. But to save an obscure hedge fund by the name of Long Term Capital Management (LTCM). Without the bail-out, the world's financial markets were on the brink of collapse.

Nicholas Dunbar's fascinating book is a well-written chronicle of these events. Like all good melodramas, it has its heroes and villains. And although we know the outcome, the twists and turns leading up to the denouement keep the reader in suspense. But the book is far more than simply a blow-by-blow description of the proceedings leading to the collapse of LTCM. Dunbar, a Cambridge and Harvard-trained physicist, gives an excellent account of the intricacies of derivatives and options pricing in which LTCM specialised.

Above all, the book is the history of an idea, one that won the Nobel prize for its originators but that was proved wrong in a truly devastating way. In the late 1960s and early 1970s, a trio of American academics (leading successful but blamelessly obscure careers), discovered ways of applying concepts from statistical physics to financial markets. Fisher Black, described by one of his close friends as "the strangest man I ever met", soon left academia to make millions at Goldman Sachs before his tragically early death. Robert C. Merton, son of the eminent sociologist Robert K. Merton, and Myron Scholes received the Nobel prize in 1997 for their findings.

The work of Black, Merton and Scholes enabled the creation of today's trillion-dollar industry of financial derivatives. The basic idea of derivatives - so called because their value is derived from, or related to,that of an underlying asset - is very simple. As Dunbar points out, the concept can be found in the clay tablets of the Babylonians. Suppose an investor holds some IBM shares. He or she may worry that the price will fall. Someone else may think it will rise. A contract can be struck between them to trade the shares at a specified price at a date in the future.

The mathematics of pricing such contracts rapidly became very complicated,and the Nobel prizewinners appeared to have found a formula that could be applied very generally. Like many innovative papers, their initial work was rejected by a number of journals before it found a home in the Journal of Political Economy . The journal, based in Chicago, was strongly oriented towards free markets and the concept of equilibrium in economics, an idea at the heart of the derivatives model. The pricing model helped realise a long-standing dream of economists to construct a complete theory in which everything can be assigned a value in a market. Until this breakthrough, conventional economics struggled with how to incorporate the future into their model. Now, it seemed that every possible state of the world, past, present and future, had a financial pay-off associated with it. Yet all models, no matter how complex, are simplifications of reality. A key theme of Dunbar's book is how the simplifications required by the economic notion of equilibrium were ultimately exposed by reality. Merton and Scholes were a driving force in LTCM. Indeed, in his autobiography provided to the Nobel Foundation, Merton depicted LTCM as the climax of his career. But the real culmination of these ideas was their empirical falsification and a $4.6 billion loss by LTCM.

The book should appeal to a wide audience. Economists should certainly read it, though one suspects that too few of them will. Dunbar describes not only the difficult concepts of derivative pricing theory, but gives insights into the practical day-to-day doings of major players in financial markets. Anyone interested in this arcane but important world will benefit from the book.

Dunbar writes in a clear and accessible manner, ranging easily from concepts of theoretical physics to Isaac Newton's loss of Pounds 20,000 in the South Sea Bubble of the early 18th century, to the haggling and the power plays of the negotiations following the collapse of LTCM. Parts of the book are not easy going for the general reader because of the difficult nature of the ideas being described. But Dunbar can be snappy as well. "The last seven days of LTCM's independent existence," he writes, "have a strange feel of their own. Thirty years of finance theory has proven itself useless. Billion dollar track records and Nobel prizes are now meaningless." A book to enjoy.

Paul Ormerod is chairman, Post-Orthodox Economics.

Inventing Money

Author - Nicholas Dunbar
ISBN - 0 471 89999 2
Publisher - Wiley
Price - £17.99
Pages - 245

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