An Engine, Not a Camera: How Financial Models Shape Markets (Inside Technology Series) [Paperback]

Many financial analysts and financial journalists have pointed to quantitative trading and the subprime mortgage markets as being the major cause behind the extreme volatility in the financial markets in the summer of 2007. This book therefore seems fitting for this particular time in financial history, if only at a bare minimum to educate the reader about the use of mathematical modeling in financial analysis and financial engineering. As the subtitle of the book indicates, the author's main thesis is that the use of mathematical models can actually change the dynamics of the markets themselves, moving them possibly to territories even more uncertain that they were invented to describe. Quantitative trading, now done by most of the major players in the financial markets, is dependent of course on mathematical modeling, some of which uses highly sophisticated reasoning patterns and artificial intelligence. Most of these models are proprietary, and therefore one cannot ascertain their efficacy in the acquisition of wealth for the organizations that deploy them. However, with a little pertinacity one can acquire a good understanding of their workings by studying the academic literature.

Some of the predominant models in the public domain are discussed in this book, mostly from an historical perspective but the author inserts some of the relevant mathematics in its appendices for the more mathematically sophisticated reader. In general the author makes a plausible case for his main thesis, but at times his conclusions are based on mere anecdotes, and he makes the typical mistake of imputing power and influence to individuals that is unsubstantiated. It is very tempting, especially among those individuals or institutions that are involved in trading, or even responsible for innovations in the same, to believe that they are the cause for some of volatility in the financial markets. But such claims, even if they seem reasonable or intuitively clear, must be substantiated with careful statistical analysis, which can be time-consuming and difficult, and few individuals it seems are willing to devote themselves to such a project. The author though is aware of this, for he states very early on in the book that historical sources may not be sufficient to allow one to decide if the influences are real. In addition, he cautions the reader to "look not just at what participants say and write but also at whether the processes in question involve procedures and material devices that incorporate economics."

The author labels the idea that economics as an academic project is actually part of economic processes the `performativity of economics', which he further breaks down into subclasses that serve to clarify the distinctions he wishes to make. One of these is more of a passive notion, called "generic" performativity, which is used to describe the participant's use of economic theories or data without emphasizing their effects on economic processes. If such effects take place, this is called "effective" performativity, which is then specialized to "Barnesian" performativity. The latter is used to describe the situations where the practical use of economic theory makes economic processes resemble what they are described to be by economic theory. Barnesian performativity is to be contrasted with `counterperformativity' where the actual use of economic models makes economic processes not resemble their description by these models. The author discusses how to detect Barnesian performativity, but warns of the difficulty in proving that movements in prices are following certain model predictions.

But aside from the qualitative/historical emphasis that the author makes in this book and the small number of unsubstantiated claims of model-market influence, the reader will take away a better understanding of such topics as the capital asset pricing model, the Black-Scholes-Merton model of option pricing, the Modigliani-Miller theory of capital structure, a description of Levy processes and their role in econometrics, and most interestingly, a different explanation for the demise of Long Term Capital Management. All of these topics, coupled with the intellectual honesty and literary skill of the author, make this book a highly interesting contribution to the financial literature.

Both the science and the art and practice of finance have experienced phenomenal growth since the 1970s.

As a science, finance has evolved from a descriptive outpost on the economic frontiers to become of that discipline's central topics. During the same period, the financial markets changed from what often seems today like sleepy outposts of liquidity into dynamic centers for financial engineering. In the 1970s, the world was being introduced to commodity hedging and options trading. By the early part of the 21st century, derivatives contracts totaling more than $273 trillion were outstanding worldwide.

Donald MacKenzie, a sociology professor at the University of Edinburgh, argues in An Engine, Not a Camera, the trends are connected. Paraphrasing Milton Friedman, he argues the emergence of economic models were an engine of inquiry rather than a camera to reproduce empirical facts. As the science of finance became authoritative, the markets were altered. These new, Nobel Prize-winning theories, elegant mathematical markets models, were more than external analyses. They evolved into intrinsic parts of the financial process.

Beginning with a discussion of the work of Franco Modigliani and Merton Miller, the Capital Asset Pricing Model and Random Walk, MacKenzie takes the reader on a journey through the development of the Black-Scholes-Merton model, The Crash of 1987, Long-Term Capital Management and the Russian government's default in 1998 to bind the threads of his thesis.

Detailed, astute, well-written, and with much of the technical detail relegated to the appendices, this book weaves economics, financial theory, economic sociology and science and technology studies into an essential read for anyone with a serious interest in the financial markets.

MacKenzie has written a wonderful and brilliant book on a very complex set of issues; the development of mathematical finance theory. He has managed to take some very complex ideas and place them in highly readable and understandable ways and in addition places you in the midst of the process and the people as it has evolved over the past fifty years.

He starts with a discussion of the commodity exchanges. The point he makes is that the exchanges could exist only with the railroad and standards, inspected wheat and corn, so that one no longer worried about a specific bushel of wheat or corn from a specific farmer, but only about the property rights to a bushel, no matter where it came from. Once that existed the whole process was off and running.

He then takes the reader through the evolution of the CAPM model with Modigliani and Miller. He adds a bit of the Samuelson saga and the growing difference between MIT and Chicago schools. Having been on the edge of that set of discussions he does a splendid job.

These observations of the schools and personalities should be exceptionally germane to the current environment which is dominated by the Harvard types who filtered through MIT. After all, Larry Summers was MIT undergrad and Harvard grad. Bernake is MIT grad. The author lends great credibility and human feeling for these characters while ensuring the understanding of the new principles developed.

He then proceeds through stock options and the Black-Scholes work, and then takes you into the pits of traders and then through the various falls that occurred over the years.

This is not a book for understanding finance. It was not intended for that. This is, however, a must book for understanding the mind-set which got us to where we are now.

There were tons of good intentions but a lack of real world reality. There is a clear understanding that the models be accepted not that they predict the actual. Like economists generally, these finance type economists develop their models in a manner which is then antithesis of engineers.

Engineers are all too often introduced to their trade by being shown examples of failure. Most engineers remember the film of the collapse of the Tacoma Narrows Bridge due to inherent instabilities in its design. Then they are told that they should never allow that to happen again. Thus, engineers over design and always look for failure modes.

These financial economists, as demonstrated by the author, are driven by concepts and theories and are devoid of any reality. Thus, the never ending collapses are inevitable with such mind sets. This book is a great lesson for the future as well as the present.