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NeilGrigg
PlanIIPhysics
BookReview:ADemonofOurOwnDesignbyRichardBookstaber
RichardBookstaberdirectedriskmanagementatZiffBrothersInvestmentsand
wasthefirmdirectorofRiskManagementatSalomonBrothers.InhisrecentbookA
DemonofOurOwnDesign,hedescribestheriskspresentinthemarketsoftoday,
specificallyinmarketswithinnovative,syntheticfinancialproducts.Mostofall,he
discussestheimportantroleofliquidityinmarketsandtheeffectsofherdingbehavior
inmarketsforderivativeproducts.
AsidefromstudyingPlanII,Imalsostudyingquantitativefinance.Inmy
financeclasses,Ilearnthatcomplexfinancialproductslikeexoticderivatives,swaps
onsyntheticfinancialproducts,andassetbackedsecuritiesallessentiallyservetolimit
andmanagerisk.Theyare.And,repeatedlyIhearthatthediversityofplayersin
financialmarketshedgers,arbitrageurs,speculators,marketmakers,hedgefund
managers,propdesktraders,andinvestmentbanksbringgreaterstabilitytomarkets
throughtheirdiversityinapproachestomarkets.Theyare.Andfinally,Ihearthatthe
legalitysurroundingmarketsnewrulestosellingassetsshort,toleverage,andothers
havebroughtunprecedentedtransparencythatremovesunfairadvantagesinthe
market.Theycertainlyshouldbe.
Yet,thetruthisthat:theyarenot.Marketsarebecomingmorevolatile.There
aremoremaniasandmorestructurallyinefficientproductsbeingtraded.Howisitthat
thelasttwodecadesoffinancialinnovationhasnotledustobesafer?Thethemeof

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Bookstabersbookisthatrecentfinancialinnovationshaveleftoursystemmorebrittle
andvulnerable.Mostofall,heemphasizestheroleofliquidityinmarketsandthe
limitsoftheefficientmarkethypothesis.Becausefinancialinnovationsoftenstemfrom
physicsanalogiestheBlackScholesoptionspricingtheoremwas,afterall,basedon
gasdiffusionequationsweoftenseethatproblemsareoftenarrangedsuchthatwe
solveforaminormaxvalue.Aswelearnedinclass,optimizationproblemslike
theseareusedinphysicsbecausetheyensurethatwecanhaveasinglenumberasour
answer.However,marketscannotbeefficientifallplayersoverspecializetothesame
parameters.Bookstaberexplainsattacksthehypothesisthatquantitativefinancemakes
marketsmoreefficientusingbiologicalandevolutionaryanalogies.Hesuggeststhat
overspecializationtoanenvironmentleadsonevulnerabletochange.Intricaterisk
managementstructuresmayactuallymakemarketsbrittlebecausetheytunetheir
optimizationstoquicklychangingmarketconditions.Moreover,whenmultipleplayers
allareusingthesameproductstohedgerisks,itoftenleadstocrisesofliquiditywhen
allplayersneedtousethehedge.Productsinthesecasesceasetobeinsurancelike
becausetheresnomethodtoexercisethemwhenpushcomestoshove.
Inmyview,Bookstaberhasasophisticatedandpracticalsetofideasaboutthe
recentshifttowardsphysicsinspiredfinancialinnovation.Formyarticlereview,Ireada
bookreviewofWeatheralls,ThePhysicsofWallStreet,whichcarriestheopposite
opinionofBookstaberandbelievesthatfinancialmarketsneedmoreandnotless
inspirationfromphysics.IagreewithBookstaberoverWeatherallbecauseIdonotfeel

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thatadvocateslikeWeatherallacknowledgehowseeingfinanceasanoptimization
problemleadstooverspecialization,causingthebrittlenessandliquiditycrises.