1/31/2018 It is not the maths that causes the crisis

Opinion Opinion
It is not the maths that causes the crisis
The problem is not the models so much as how we use them, writes James Weatherall

James Weatherall
FEBRUARY 15, 2013

On October 19 1987, the floor fell out from under world financial markets. The Dow Jones
Industrial Average fell 508 points, or almost 23 per cent. “Black Monday”, as it has come to be
known, remains the largest single-day market drop in history.

The culprit was a new kind of investment product known as portfolio insurance. Based on a
mathematical model for pricing options, portfolio insurance consisted of a strategy of selling stock
market index futures short while buying other equities. According to the Black-Scholes model, an
event such as Black Monday could not happen. It was so unlikely it should not have occurred in the
lifetime of the universe.

After the crash, investors screamed that the maths behind portfolio insurance had failed. And since
then, history has repeated itself. After Long Term Capital Management imploded in 1997, the
models were to blame. The 2007-08 crisis? Again the models. So, too, with the “London whale”
fiasco that cost JPMorgan Chase upward of $6bn last year. The popular response is always the
same. As Warren Buffett put it in 2009: “Beware of geeks bearing formulas.”

But criticising the maths is easy. The models are not the problem – it is how we think about
models, and how we use them as a result.

The models at the heart of modern finance are often said to be mathematically complex and
impossible to understand. But this belies the fact about how they work. It is the world that is mind-
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bogglingly complex. The models are dramatic simplifications, designed to give some small
quantitative purchase on problems that would otherwise be intractable.

To achieve these simplifications, model builders make assumptions about how the world works –
assumptions that rarely hold exactly and often fail spectacularly.

But this should not militate against using models as a central part of financial decision-making so
much as sharpen our focus on just what assumptions our models make, and how those
assumptions can and will fail.

Not everyone was wiped out in the 1987 crash. One Chicago-based firm, O’Connor & Associates,
weathered it well. The reason was not that it avoided models or that it stayed clear of the options
markets. Rather, it was that the firm’s co-founder, Michael Greenbaum, and its whizz-kid risk
manager, Clay Struve, saw through the assumptions. They recognised that the Black-Scholes model
essentially neglected market crashes. So they tweaked the model.

While everyone else plugged along, blithely mistaking model for reality, O’Connor traders used a
broader array of methods. These methods, which included stress-testing the firm’s portfolio for
events far beyond what the models said was possible, were designed to perform well even if
markets did the “impossible”.

For them, the models were a source of information, tools that could provide some quantitative
insight, but no more. A model such as Black-Scholes can tell you how much an option should be
worth if the period from now to the option’s expiration is filled with “normal” trading days – and
not what will happen if markets go haywire. This sort of best-case-scenario information can be
crucial to decision-making, but it is never the whole story.

The trouble with models arises not because they can sometimes fail but because they are often built
in ways that force us to trust them implicitly. Most investment companies use computerised risk
management systems to limit the risk traders can take. These systems are built into the

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infrastructure of a firm’s operations and both traders and managers rely on them. But they are as
sensitive to assumptions as any other model – and just as liable to fail. Indeed, a failure in these
systems was what initially masked the London Whale trades from JPMorgan executives, allowing
losses to spiral out of control.

Even the language of traders, who often speak in a code of Greek letters such as delta and gamma,
rests on acknowledged assumptions about the likelihood of market crashes. And it is here that the
real danger lies. We should fear models only insofar as we are able to forget that we are using them
at all. That is when it is easiest to lose sight of where the simplifications end and the real world
begins.

The writer is a professor at the University of California and author of ‘The Physics of Wall Street’

Copyright The Financial Times Limited 2018. All rights reserved.

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