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Mathematics & The World-Wide Financial Crisis

By Ellis D. Cooper, Ph.D., May, 2009

“Worldwide Worry”
“Worldwide Worry” headlined The Boston Globe on Tuesday, October 7, 2008.
Above the fold stories included “Ominous signs of pullback by businesses,” and
“Markets tumble amid doubts on US stability.” The heat producing this meltdown had
been turning up for a year or more. A large number of homeowners had to default on
their mortgages; the major investment bank Bear Sterns built a house of cards to make
money hand over fist, went belly up and was sold off; housing prices fell and the supply
of credit dried up; the financial-services firm Lehman Brothers set the record for largest
bankruptcy in US history; the banks in the entire country of Iceland melted away; and the
largest automobile manufacturers in the US began to dissolve.
Seemingly humble, Former Chairman of the Federal Reserve Bank said, “[W]e’re
not smart enough as people. We just cannot see events that far in advance.” The “not
smart enough” people were the mathematical economists on staff at the Federal Reserve
Board. He implied that if the brilliant people hired by the government – product of the
most prestigious business schools in the country – could not predict this calamity, then
nobody could. What this leaves out is that several other people did foresee the possibility
of the collapse based not just on readily available numerical data, but on a fundamental
theoretical criticism of academic mathematical finance.

Alchemy and Free Money

Limitless money and limitless time to play with it would be nice. Serious geniuses
– including Isaac Newton – pursued the Alchemical goal of creating The Philosopher’s
Stone, a special material with the power to convert any material object into gold and to
confer immortality upon a human being. They failed. Second best would be a practical
method for getting free money. Probability theory originated in the seventeenth century
as a mathematical endeavor to solve gambling problems. As in so many other areas
grounded in concrete problems – such as geometry – mathematical questions arose in
probability theory that demanded more and more abstract levels of research. The work of
a dozen or two geniuses yielded by 1900 a probabilistic mathematical machine for
reasoning and calculating price and risk in financial markets.
Gambling is all about getting money fast for free – with the risk of losing the
wager. If there is no magic calculation that guarantees winning, at least one may hope for
a risk formula. With that one could judge whether the reward would be worth the risk.
Loaning money is all about gambling on getting paid back – with the reward of interest
payment. Of course, a loan is not free from the borrower’s point of view, but at least it is
fast money.
Americans love borrowing. People increasingly “live on credit.” But a century
ago except maybe in a bar or country store the idea of “Buy Now Pay Later” didn’t exist.
Credit cards did not exist. The virtues of avoiding luxury, of frugality, and of avoiding
debt governed many daily lives. However, mathematical, scientific and engineering
innovations of the Industrial Revolution sparked huge demand for must-have
commodities such as radios, phonographs, washing machines and refrigerators. By the
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1920’s and 30’s these wonderful but expensive things included automobiles. To compete
with the Ford Motor Company “Layaway Plan” – basically an organized way to save up
for a car – the idea of “Automobile Loan” was conceived, born and raised by the General
Motors Assurance Corporation. In other words, General Motors – along with department
stores – helped create “modern consumer capitalism.” After World War II the consumer
credit business blossomed big-time and GMAC expanded into home mortgages. Banks
gamble on their borrowers and big banks gamble big.

What is it Like to be a Mathematician?

What has mathematics got to do with our worldwide financial convulsion? For
sure, banks, businesses, investors, and traders perform arithmetic calculations – a lot of
them, and fast. But there is more to mathematics than arithmetic, and there are
mathematicians who are not even remotely as good at “doing the math” as a pit-bull
trader. The problem with understanding the difference between mathematics and
arithmetic is that nobody but mathematicians know what mathematics is. So, an analogy
is needed.
Just about everybody with any interest in sports knows about Michael Jordan. His
grace, power, and competitiveness are legendary. Certainly he came to the game with
extraordinary physical and mental gifts; we also know that he practiced extremely hard to
refine his skills, making his performance appear almost effortless. But even if you were
severely challenged to sink a free throw shot, you could watch him and feel vicariously
what it’s like to fly and twist in space and dunk a seemingly impossible shot.
Now, imagine a new kind of basketball played in outer space, with ever-changing
teams and players, in a playing space the size of a space station, with multiple hoops, and
machine shops where players are encouraged to invent and build inter-communicating
machine helpers for playing defense, making multi-hoop trick shots, and so on. And
assume that these helper machines can be passed from one generation of players to the
next. The differences between this imaginary physical game and mathematics are that
mathematics is a real “mental game,” that it is way more fun, and that – most
importantly – over hundreds of generations it is cumulatively meaningful.
Rigor cleans the window through which intuition shines. The mental gift of
mathematical intuition is a light by which patterns are seen. But every light has some
colors in it, and different colors bring out different patterns. In other words, mathematical
intuition may err. But to reason and calculate correctly about whatever pattern is seen
requires penetrating attention to details. Mathematicians seek truth – that is, truth about
patterns, about patterns of patterns, searching ever more for profound underlying
interconnecting truths. They strive to prove – not just state – the truths that they intuit.
The statement of a truth in mathematics is called a theorem and for each theorem there is
a logical proof. The chore of mathematical rigor is to make sure that there are no holes in
the logic – that the arguments are airtight and streamlined. Well, ideally. What really
happens is that there are claims and evidence. Ultimately, there must be agreement
among the top experts about whether a proof – the logical evidence for a claim – suffices.
Nevertheless, it is entirely possible that great logical care is lavished on erroneous
intuition. When a lot of money is involved the results can be near catastrophic.
Mathematics is not the same as mathematical science. If mathematics seeks
profound truths underlying patterns, then a mathematical science seeks profound truths
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underlying patterns that relate measurements. All measurements come down to counting.
For example, time is measured by counting clock ticks, and money is measured by
counting dollars. Of course, there are an unlimited number of quantities that can or might
be counted. A mathematical scientist seeks the simplest patterns relating measurements to
one another. That is science because a proposed pattern can be refuted by more
measurements, and mathematical because studying patterns involving numbers –
reasoning and calculating – is best expressed using mathematical machinery. For
example, one of the best tricks in mathematics is to invent new kinds of numbers to
expand the possibilities for reasoning and calculating. So, although counting cannot ever
yield, say, the square-root-of-two, it is mysteriously useful to be able to reason about and
calculate with measurements if square roots are allowed in reasoning and calculation.
Making measurements is an engineering problem. Originating ideas about what
patterns to seek requires intuition – and luck. The trick is to use the mathematical
machinery to build a streamlined imaginary universe – often called a “model” – intended
to mimic measurements in our messy real universe. The ideas come from recognizing
analogies, making guesses, tinkering with the machinery, seeing the numbers it generates,
comparing these numbers with measurements, and then guessing and tinkering some
more. This activity is so much fun – and intellectually rewarding – that some people get
deeply obsessed with it. We call them mathematicians and mathematical scientists.
The super-star mental gymnasts of mathematics have contributed for thousands of
years and from diverse cultures. Their understanding and inventiveness undergirds all of
engineering, including electronics and computers, and increasingly all of science,
including biology and medicine. The on-line Mathematics Genealogy Project presents a
searchable “family tree” of mathematicians in which a “parent” is a supervisor – or
among the supervisors – of the doctoral work of the “child.” For each individual the chart
provides the year that the doctorate was granted together with the number of “children”
and the total number of “descendants.”
For example, Henri Poincaré achieved his doctorate in 1879, had 3 students, and
they were his only descendants. Succinctly, (1879, 3/3). As a youth Poincaré was already
called a “monster of mathematics” and went on to create entire fields of research, and
among other prodigious achievements to anticipate key ideas leading to the relativity
theory of Albert Einstein. In particular, Poincaré supervised the work of Louis Bachelier
(1900, 0/0), who is universally acknowledged as the originator of mathematical finance.
Subsequently, two of the students of Jacques Hadamard (1892, 6/1695) – Paul Lévy
(1911, 4/377) and Szolem Mandelbrojt (1923, 10/928) – indirectly impinged on
mathematical finance through Benoit Mandelbrot (1952, 8/12), who was a student of
Lévy and a nephew of Mandelbrojt.

The Bachelier Financial Universe

Of the previously obscure mathematician Louis Jean-Baptiste Alphonse Bachelier
(1870-1946), it is known that his father was a businessman, a bureaucrat, and an amateur
scientist. His mother was a banker’s daughter, and he had a grandfather in the “financial
business.” In some sense, then, Louis Bachelier was born into the house of finance. His
parents died when he was a teenager, he became the head of the family enterprise, and so
he had to gain intimate acquaintance with the world of financial markets.
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At the Sorbonne, Bachelier was an undistinguished student. However, if a

dumbed down definition of “genius” is originality that changes the world, his doctoral
thesis Théorie de la Spéculation – accepted with praise by Poincaré – is a work of
genius. It was the first high-level mathematical theory of finance, but attracted scant
attention for half a century.
A concept or idea or notion is interesting if there is much to say about it; it is
important if there are numerous interesting ways to express it. Examples of concepts both
extremely interesting and important are “computation” and “entropy.” Another such
concept called “Brownian motion” entered the scientific zeitgeist in two different and
seemingly unrelated ways just around the turn of the twentieth century.
First, in physics – defined as the scientific study of motion – the acceptance of
“molecular reality” underlying the illusory appearance of solidity in the everyday world
sprung from the gradual physical and mathematical understanding of “Brownian motion.”
Robert Brown (1773-1858) a botanist using a microscope observed that tiny
particles within pollen grains suspended in water seemed to have a life of their own: they
darted around like drunken sailors savaging a port. Previously, others had observed this
motion and attributed it to life force, but he examined many, many substances and
concluded that the movement was not a manifestation of life. In 1905 Albert Einstein
(1879-1955), working on the theory of the physical existence of atoms, predicted the
possibility of observing such motions – without knowing they had already been observed!
Jean Perrin (1870-1942) knew about Brownian motion and about the prediction of
Einstein, and after meticulous experiments – involving lots of counting – by 1909
published Brownian Movement and Molecular Reality. He concluded that the particles
Brown observed were moving because they were being bombarded at random by
invisible molecules of the water in which they were suspended. Perrin was awarded the
1926 Nobel Prize in Physics “for his work on the discontinuous structure of matter.”
Scientists everywhere climbed on the molecular reality bandwagon and have been riding
it ever since.
Imagine a gigantic inflated balloon nudged by hundreds of ping-pong balls shot
by playful little kids running every which way. Any impact moves the balloon a tiny bit
in one direction or another at random. Of course, talking about “random” impacts
introduces probability theory into any mathematics destined to provide a mathematical
model of Brownian motion. It turns out that the most common probability concept of all,
something called the “normal probability distribution” – high school students call its
Cartesian graph the “bell curve” – is perfectly adapted to modeling Brownian motion.
Norbert Wiener (1894-1964) originated the rigorous theory in a paper published in 1923
– fully aware of Einstein and Perrin – acknowledging a key conversation with Paul Lévy,
Benoit Mandelbrot’s doctoral supervisor. The Wiener-Lévy process models Brownian
motion and its cornerstone is the normal probability distribution.
Second, the fundamental intuition of Bachelier finance is that price is like that
giant balloon, impacted by “ping-pong” trading decisions governed by the Wiener-Lévy
process, although of course in 1900 Bachelier could not call it that. The two most
important implications of this model are that a price change at one time has virtually
nothing to do with a change at a later time – price has no memory; and that price changes
are overwhelmingly small. The giant balloon has inertia and does not move much per
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ping-pong impact. The Bachelier intuition is that large price changes are extremely
unlikely, that price changes continuously.
The explosive history of the Bachelier financial universe is shot through with the
Nobel Memorial Prize in Economic Science (briefly denoted by N and followed by the
date of award). Around 1958, Bachelier’s largely ignored work was brought to the
attention of Paul Samuelson (N, 1970) at the Massachusetts Institute of Technology
(Norbert Wiener’s home base) by Leonard J. Savage, a student of economics under the
supervision of Harry J. Markowitz (N,1990), who initiated “modern portfolio theory,”
1955-1956. William F. Sharpe (N, 1990), who also studied under the supervision of
Markowitz, shared in the development of the “capital asset pricing model,” 1961-1966.
Eugene F. Fama studied mathematical economics as a doctoral student of Benoit
Mandelbrot, and originated the “efficient markets hypothesis,” 1964. Development of the
“Black-Scholes option valuation formula,” 1973 was shared, among others, between
Myron S. Scholes (N, 1997) who worked with Fama, and Robert C. Merton (N,1997),
whose graduate work was supervised by Samuelson.
The Bachelier financial universe is a Platonic realm of perfectly rational denizens
who all have the same information about the financial objects – for example, “stocks” –
on which they place bets. It is assumed, therefore, that the price of an object “reflects” the
universally known information – this is the “efficient markets hypothesis.” These entities
all wish to get the “greatest bang for the buck,” limited only by their tolerance for loss.
Fear of loss is represented by a number called “risk” and is a statistical quantity –
“variance” – calculated using a formula that assumes price changes conform to the
“normal probability distribution.” Denizens can borrow as much money as they want at a
guaranteed interest rate, so they can even borrow money for placing bets.
They can also loan as much money as they wish at a guaranteed interest rate – by
buying “bonds.” They can form sets of bets – “portfolios” – that combine stocks and
bonds and all sorts of other financial objects. They guesstimate the expected value and
the risk of the objects in the set, and calculate the combined expectation and risk of the
whole set. By clever adjustment –“diversification” – of the quantities of objects in the set
they minimize the risk for a given expectation – this is called “modern portfolio theory.”
Given a guesstimate of the risk of the entire set of all possible financial objects – the
“market risk” – they can also calculate the expectation of a financial object being
considered for addition to the set – this is the “capital asset pricing model.”
When someone has a great idea you can bet that others will try to do even better.
In fact, that might even be the definition of “great idea.” In any case, human beings have
invented many unique financial objects – with dependencies of the prices of some upon
the prices of others. Those whose prices do not depend on the prices of others include
basic objects such as bonds and stocks. Those whose prices do depend on others are
called “derivatives,” such as an “option” whose price depends on the interest rates of
bonds and the prices of stocks. In the Bachelier financial universe there is a calculation
for the price of an option – “Black-Scholes option valuation formula” – that, again,
assumes the normal probability distribution for stock price proportional changes.
Companies use derivatives to reduce risk. Change in interest rates, currency exchange
rates, supplies of raw materials, and chance of default on loans are some of the sources
of corporate risk. Speculators use derivatives for hedging their bets.
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Calculating risk of a portfolio becomes ponderously complex as different sorts of

derivatives are included. The Bachelier financial universe includes a calculation of
portfolio risk – based of course on the normal probability distribution – using a more-or-
less lengthy sequence of recent financial object prices. This is called the “value-at-risk
calculation.” It comes up with a number that represents the probability of a portfolio not
losing more than a specified number of dollars in value in the near future.
In summary, the grand edifice of Bachelier Finance is erected on mathematical
pillars called “efficient markets hypothesis,” “capital assets pricing model,” “Black-
Scholes option valuation formula,” “value-at-risk calculation,” and “modern portfolio
theory.” The pillars are set in the bedrock of the rigorous Wiener-Lévy process that
models Brownian motion and hence captures Bachelier’s intuition that price changes
continuously without memory.

The Mandelbrot Financial Universe

The center of the Massachusetts Institute of Technology campus is Killian Court.
Carved in large Roman letters on the friezes of the marble-clad buildings surrounding the
court are the names of legendary scientific celebrities such as Aristotle, Newton,
Franklin, Pasteur, Lavoisier, Faraday, Archimedes, da Vinci, Darwin, and Copernicus.
Above each of these names are clusters of related names. In particular, at Building 2,
Kepler, Newton and Poincaré appear together.
As already recounted, Louis Bachelier was a student of Poincaré. His most basic
tools for the study of price change were the differential and integral calculus – the
mathematical study of change – independently originated by Isaac Newton (1643-1727),
and the mathematical probability theory initiated in part by Pierre de Fermat (1601-1665)
and Blaise Pascal (1623-1662).
Reaching a generation further back in time, Benoit Mandelbrot (born 1924)
aspired to emulate Johannes Kepler (1571-1630). After “playing” with a large number
of alternative ideas, Kepler articulated laws of planetary motion, providing thus an
impetus for the theory of universal gravitation originated by Isaac Newton.
Mandelbrot is a Lithuanian whose family had immigrated to France. As a young
man he skillfully survived German-occupied France and then he moved to the USA. His
father had been an inventor and a not-too-successful businessman, and for a while his
mother was a dental professional operating out of the family apartment in a low-class
neighborhood of Paris. A grandfather was integral to an intellectual lineage of Judaism,
and his uncle – Szolem Mandelbrojt, previously mentioned – was a world-class
mathematician, and his nephew’s early mentor. Thus, it may be said that Mandelbrot was
born into the house of mathematical science.
The sort of mathematical super-stars Mandelbrot grew up knowing – and those he
encountered along his extraordinary scientific career – would be like a young talented
basketball player happening to play on teams with legendary stars such as Bill Russell,
“Magic” Johnson, Larry Bird, and Michael Jordan. Add some time hanging out with
super-stars of other sports, such as hockey player Wayne Gretsky and golfer Tiger
Woods. In Mandelbrot’s life the names are Robert Oppenheimer (“the father of the
atomic bomb”), John von Neumann (“the father of the computer”), Norbert Wiener (“the
father of cybernetics”), and George A. Miller (an uncle of cognitive science). Add
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anthropologist Margaret Mead, paleontologist Stephen Gould and psychologist Jean

Piaget.
A tree of a man, Benoit Mandelbrot has had a rough life, obsessed with his
“Keplerian dream” to create a science of roughness. With a “freakish geometric gift,”
prodigious curiosity, uncanny memory and utter mastery of probability theory, he is a
ferociously competitive survivor and maverick scientist. He can be a completely
charming companion and storyteller – and he can be dismissively argumentative. Thus,
he has many, many friends – and he has had a small number of enemies.
Nature is shot through with catastrophe, turbulence and roughness. Life is buoyed
and lashed by luck. Mandelbrot’s singular achievement is that he originated the
mathematical science for measurement and classification of roughness in nature – he calls
it fractal geometry. He fulfilled his lifelong scientific ambition, “to feel the excitement of
being the first to find a degree of order in some real, concrete and complex area … where
everyone else saw a lawless mess.” Mandelbrot is to roughness as Kepler is to celestial
physics.
If Bachelier’s intuition was that price change is continuous, then Mandelbrot’s
intuition is that, No! Nature is discontinuous – it is rough all over. A hard-core conflict
between two intuitions, one half a century old emanating from a scientific genius, the
other a century old insight of a mathematical genius; one flowering from an original
geometry of turbulence and roughness, the other morphing into an elegant algebraic
reasoning and calculating machinery; one advanced by a small band of revolutionaries,
the other defended by an army of counter-revolutionary academic mathematicians and
physicists – transmogrified into Wall street rocket scientists – frames the gripping story
of how Mandelbrot’s David barely nudged the Bachelier Goliath. Until lately.
The geometry studied by high school students is the geometry of nice flat objects
such as lines and planes, triangles and circles. Likewise, the heart and soul of calculus is
smoothness. Assuming that a mathematical variable is changing smoothly lubricates
algebraic machinery for reasoning about – and calculating – the behavior of the variable.
But the real world is neither flat nor smooth. For example, in engineering the
behavior of an engine – be it hydraulic, pneumatic, acoustic or electrical – is
mathematically analyzed in terms of its response to a shock. The resulting transient
behavior settles down to a stable situation – until the next shock. For example, airplane
wings must be designed to withstand the turbulence of air during flight. In biology one
encounters the idea of “punctuated equilibrium” – long periods of stasis interrupted by
rapid, catastrophic change – wherein the creation of new species is rare and rapid. This
idea is contrasted with “gradualism,” the notion that evolution is generally smooth and
continuous. And in physics the standard interpretation of quantum mechanics holds that
an atomic system evolves quite smoothly – until it is measured. In that view,
“measurement collapses the wave function,” a seriously discontinuous event.
Bachelier published his thesis and five other books, all on probability theory, and
altogether fifteen scientific papers, mostly on probability theory. Then, as already noted,
his ideas evaporated into obscurity for decades.
Mandelbrot is without any doubt a prolific scientific genius, having published
hundreds of papers in a dozen different branches of science, and more than two dozen
technical books in several languages. His vita alone is a fifty-page booklet that lists his
publications, the television programs on him and his work, interviews with him for
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dozens of periodicals, and honorary doctorates from institutions all over the world.
Among the prizes listed are the Wolf Prize in Physics 1993: “by recognizing the
widespread occurrence of fractals and developing mathematical tools for describing
them, he has changed our view of nature”; and the Japan Prize 2003: “for the creation of
universal concepts in complex systems - Chaos and Fractals.”
Mandelbrot’s Hypothesis applied to price change is that – like most everything
else in the real world – price change is discontinuous. This flatly contradicts the
fundamental assumption of Bachelier finance – the one taught in business schools and
trundled on Wall Streets worldwide – and the reaction of the mathematical finance
community has been … largely dismissive. Until lately.
If there is to be a Mandelbrot Financial Universe, it will extend the Bachelier
Financial Universe as the Milky Way extends the Solar System. Mandelbrot has
generalized the “mild” variability studied in Bachelier finance by providing mathematical
machinery for simulating, reasoning and calculating about “wild” variability – abnormal
probability distributions.

Cootner Assails the Mandelbrot Hypothesis

By 1964 the idea that prices of financial objects such as stocks and commodities
are best modeled by the continuous Wiener-Lévy process – or its discrete approximation
called a “random walk” – was established enough to call for publishing a collection of
academic papers on the origins, justification, refinement, testing, and re-examination of
the idea. MIT Press –the publishing arm of the Massachusetts Institute of Technology –
released The Random Character of Stock Market Prices, edited by Paul H. Cootner
(1930-1978). It includes a translation of Bachelier’s doctoral thesis, a paper on
Mandelbrot’s Hypothesis by Eugene Fama, a paper by Paul Samuelson on “rational
pricing,” and a seminal work by Benoit Mandelbrot, The Variation of Certain
Speculative Prices.
As editor, Cootner certainly had every right to organize the book as he deemed
useful, including the right to add comments of his own. Strangely, he chose to comment
only on the one by Mandelbrot. He wrote that Mandelbrot “[w]ith determination and
passion … has marshaled as an integral part of his argument evidence of a more
complicated and much more disturbing view of the economic world than economists have
hitherto endorsed.” He goes on to criticize Mandelbrot’s evidence, method, and
conclusions. He concludes that if Mandelbrot is right, then “[a]lmost without exception,
past econometric work is meaningless.” Mandelbrot was never given an opportunity of
reply to Cootner’s excoriating diatribe, and could not withstand excommunication from
the church of mathematical finance.
Forty-five years later – in the midst of World-Wide Depression II – the
Mandelbrot Hypothesis is being revived in articles appearing in the New York Times,
Scientific American, and the Financial Times. In fact Mandelbrot has changed the
English language twice – first with his word fractal, and now with the word
(mis)behavior applied to markets and prices. His 2004 book with Richard L. Hudson, The
(Mis)behavior of Markets, A Fractal View of Risk, Ruin, and Reward has been issued in
paperback and recently reprinted with an up-to-date preface both in the US and UK.
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Taleb Assails Bachelier Finance

Personal disclosure. Last year after a small reflection I concluded that luck – good
and bad – had a very large influence on my life. This is not much of an Earth-shattering
insight. In a bookstore one day I was riveted by Nassim Taleb’s 2004 book, Fooled by
Randomness, The Hidden Role of Chance in Life and in the Markets. His 2007 book, The
Black Swan, The Impact of the Highly Improbable, is dedicated to … Benoit Mandelbrot.
Nassim Nicholas Taleb (born 1960) vehemently assails Bachelier Finance both as
a very successful contrarian Wall Street trader and as an erudite mathematically trained
philosopher. The philosophical question called “the problem of induction” is basically
whether truth about the future can be induced from knowledge of the past. That question
is even built into the prospectus of an investment fund, which is legally required to
declare that “[t]he performance data shown represents past performance, which is not a
guarantee of future results.” Taleb writes, “[b]efore the discovery of Australia, people in
the Old World were convinced that all swans were white, an unassailable belief as it
seemed completely confirmed by empirical evidence. The sighting of the first black swan
… illustrates a severe limitation to our learning from observations or experience and the
fragility of our knowledge.” Price discontinuities are like black swans. Taleb anti-
religiously castigates the “value-at-risk calculations” derived from the comfort food for
Wall Street cooked up by Bachelier.

Bachelier Finance is Flawed

In the UK, Chairman Lord Turner of The Financial Services Authority – an
independent non-government body funded by the firms it regulates – recently published
The Turner Review of “the events that led to the financial crisis and to recommend
reforms.” Regarding “value-at-risk calculations” it is written that, “[s]hort-term
observation periods plus assumption of normal distribution can lead to large
underestimation of probability of extreme loss events.” Once again, the point is very
simple. Price change may roll along with mild jumps for a while, but there is no way to
predict when it will hit a bump and make a wild leap, jarring the market and surprising
everyone.
The report declares that individual market participants, government regulators and
academic researchers – the Bachelier rocket scientists – had “misplaced reliance” on
sophisticated mathematics. The pristine ivory tower mathematics used to measure and
manage risk engendered false confidence that other indicators of increasing risk – for
example, rapid credit extension and balance sheet growth – could be ignored with
impunity. Warren Buffett has said, “If you stand up in front of a business class and say a
bird in the hand is worth two in the bush, you won’t get tenure … Higher mathematics
may be dangerous and lead you down pathways that are better left untrod.”

A Post-Bachelier Financial Universe?

Changing the mathematical culture in the world of finance is a formidable
challenge. Perhaps a period of time which has witnessed solution of long-standing
mathematical problems such as Fermat’s Last “Theorem” (1637; Theorem in 1994), the
Four Color Conjecture (1852; Theorem in 1976), the Poincaré Conjecture (1904;
Theorem in 2004), and the Weil Conjectures (1940’s; Theorems in 1974), may see
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creation of a new mathematics to supplant the useful but over-specialized Bachelier

Finance.
There is no formula for human fear, greed, and stupidity. A model of price
behavior is no more a model of human behavior than a model of temperature behavior is
a model of molecular behavior. Perhaps a mathematical science of financial behavior
should take into account facts such as “markets are not perfectly efficient,” “people are
not good guardians of their own self-interest,” “human beings evolved in a very uncertain
world and therefore have inherent limitations and flaws in the way they think and act,”
and “political systems necessarily bias perceptions of the powers-that-be in favor of
maintaining their power.” A Post-Bachelier Financial Universe might do well to also
model cooperative and feedback effects between the individuals and institutions acting in
markets, and take account of the “butterfly effect,” especially because the speed of
transactions is accelerating due to breakneck advances in electronic, optical, and quantum
technology.

Bachelier Finance is So Twentieth Century

Basketball teams have winning and losing streaks; individual players during
games have runs of scoring shots and then go “cold” for a series of shot attempts.
Clustering appears in price series too, but Bachelier’s theory is blind to these effects.
Discontinuity and clustering are its bane. Mandelbrot offers new mathematical tools for
studying price changes, but physicists flock to finance, attracted by increasing quantities
of hard data – and by the high salaries on Wall Street. Thus, we have “econophysics.”
The study of motion naturally includes the absence of motion – rest – which the
physicists call “equilibrium.” A swinging pendulum eventually comes to rest because
friction at the joint from which the bob hangs irreversibly converts motion energy into
heat energy. Indeed, a fundamental law of physics says that any isolated physical system
eventually comes to rest. Standard economic theory assumes there is an equilibrium price
for each item traded. But no one has ever seen a price achieve equilibrium. Brownian
motion and equilibrium are physicist concepts that have failed financial economics.
If financial economists need new ideas, perhaps they ought to encourage their
students to study more mathematics rather than so willingly allow physics students to
invade their precincts. Mathematics is not shackled to physical reality, its ideas are free to
roam a cosmos in which physics is nought but a single star.
Mathematician Mohammad Bin Musa Al-Khowârizmi (790-840) gave to us in his
name – transformed by translation into Latin from Arabic – the word algorithm which
now means a method of calculation. His work Hisab al-jabr w’al-muqâ-balah was the
first and enormously influential book on the “science of the reunion and the opposition”
for solving equations. Its title originates the word algebra. Through the centuries
algorithms and algebra have generated a universe of concretions including computer
programs and abstractions including the algebra of algebra – which is called category
theory. Its special study called “topos theory” is uniting theories of geometry and logic
within mathematics; “higher-dimensional category theory” is actively studied by
theoretical physicists; and category theory is unifying theories of parallel computation.
Financial economists ought to be aware of this scientific work because it provides new
options for inventing metaphors. The old-guard of financial economists probably will not
be able to look away from their burnished ideas. Paul Samuelson is purported to have
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said, “Funeral by funeral, science makes progress.” Perhaps the next generation of
finance students will boldly realize that mathematics is the ultimate tinker-toy of
metaphor.