PhysicsOfWallStreet

The Physics of Wall Street (James Weatheral)l

  • Quick read. Too much useless bio, learned things.
  • If the probability of getting heads is 50%, then the probability that the percentage of heads you actually got would differ by 50% by any given amount get smaller and smaller the more times you flip the coin. There's something fishy about this definition of probability, since it uses ideas from probability to say what probabilities mean.
  • Any predictable events would already be reflected in the current price of a stock or bond.
  • The efficient market hypothesis was later rediscovered to great fanfare, by University of Chicago economist Eugine Fama, in 1965. Nowadays, the hypothesis is highly controversial. Some economists, particularly member of the so-called Chicago-school, cling to it as an essential and irrefutable truth.
  • The rate of return on a stock is related to the change in price by a logarithm. So if rates of return or normally distributed, they probability distribution of stock prices should be given by a log-normal distribution. Upshot of this is that the rate of return undergoes a random walk, not the price.
  • Investors dont really care about the absolute movement of stocks, they care about the percentage change. So, we should be interested in the logarithms of prices because logarithms of prices better reflect how investors feel about their gains and losses. (The difference between log(10) and log(11) is the same as the difference between log(100) and log(110).
  • People have criticized mathematical modeling of financial markets using methods from physics on the ground that the stock market is composed of people. Osbornes's argument is historically interesting, it shows that mathematical modeling of financial markets is not only consistent with thinking about markets in terms of the psychology of investors, but that the best mathematical models will be ones that take psychology into account.
  • In 1971, Nixon ended the convertibility of the US dollars to gold.
  • dynamic hedging, the basic idea behind Black-Scholes, gave investment banks the tool they needed to manufacture options.
  • Another one of the Prediction Companies ideas was to use many different models at once, each based on different simplified assumptions about the statistical properties of different assets. The different models then "vote" on trades - and a strategy is adopted only if the models were able to form a consensus that it would likely be successful. Allowing many different models to vote identifies which trading strategies are robust, in the sense that they aren't sensitive to the special details of a particular model.
  • Projections for the future costs of Social Security were based on the expected rate of inflation, which in turn was based on CPI. Moynihan and Packwood (Senators) realized that if the official rate of inflation could be lowered, the income from the Social Security tax would rise, and the costs of administering the program would fall. The effect would be to raise taxes and reduce entitlements, relative to the real buying power of money, without acknowledging that you were doing so.
  • We should devote the same resources to staving off economic calamity as we devote to protecting ourselves from other risks. Organization like the Federal Reserve and the Securities and Exchange Commission, even the World Bank, should be the most sophisticated players in the game – and if these groups are not up to the task, we need some new research organizations devoted to interdisciplinary economic research to help guide them. The people charged with running the worlds economies should be as good as Renaissance. In fact, they should be better.

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