The Stock Market and Finance From a Physicist's Viewpoint

Rating:
Summary: Outstanding, still fresh after a generation
Review: It was a bit of a shock for me to read this book, because I had already been exposed to the random walks idea long before I found it. I had already learned about Black-Scholes-Merton and had read about "The Holes in Black-Scholes" (that's the name of a paper by Fischer Black). But here we have a physicist who dissected the ideas of economists (mostly statistical ideas) in the 1960s and 1970s, and anticipated a lot of what has been done since.

Osborne repeatedly picks at assumptions that have tripped up those who blindly misapply BSM, such as the idea of "continuous markets". His section on market making is better than anything else I have read on the subject (though I have not been able to find much on this subject). It illustrates that market makers create the illusion of continuity on a price chart, and for them to function the way they do, the market either must have "down time" or they must be able to halt the market occasionally and restart it (or both).

This book is very rough: it's a collection of lecture notes, and the pictures are drawn by hand. This will make any reader uncomfortable who insists on having everything look like it came out of PowerPoint or Mathematica. Younger readers who don't remember what life was like before computers were common would probably find it quaint.

Rating:
Summary: Outstanding, still fresh after a generation
Review: It was a bit of a shock for me to read this book, because I had already been exposed to the random walks idea long before I found it. I had already learned about Black-Scholes-Merton and had read about "The Holes in Black-Scholes" (that's the name of a paper by Fischer Black). But here we have a physicist who dissected the ideas of economists (mostly statistical ideas) in the 1960s and 1970s, and anticipated a lot of what has been done since.

Osborne repeatedly picks at assumptions that have tripped up those who blindly misapply BSM, such as the idea of "continuous markets". His section on market making is better than anything else I have read on the subject (though I have not been able to find much on this subject). It illustrates that market makers create the illusion of continuity on a price chart, and for them to function the way they do, the market either must have "down time" or they must be able to halt the market occasionally and restart it (or both).

This book is very rough: it's a collection of lecture notes, and the pictures are drawn by hand. This will make any reader uncomfortable who insists on having everything look like it came out of PowerPoint or Mathematica. Younger readers who don't remember what life was like before computers were common would probably find it quaint.

Rating:
Summary: Careful empiricism instead of the usual 'econo-logic'
Review: Osborne was a physicist who observed that stock prices appear to be distributed lognormally. Mandelbrot pointed out a year later (1963) that this can't be true, that price distributions look Paretian, have exponentially decaying tails with infinite standard deviation. However, no one has yet been able to turn Mandelbrot's observation about asymptotics of market prices into trading rules (what are the dynamics?). In contrast, the Black-Scholes model, the mathematics of derivatives and option-pricing, follows from the lognormal approximation (see Hull, e.g.). Traders who make money apparently don't use academic option pricing theory (it underprices out of the money trades), but texts and scads of academic papers are written using it because no one knows how to do anything else yet.

Lognormality is the last part of Osborne's book. The first chapters are even more interesting. There, Osborne tears the 'mathemology' of Samuelson's Economics text to shreds by pointing out that the famous supply-demand curve can't be constructed from any sort of data. The main point is that price does not exist as a function of either supply or demand. Example: suppose that 25 tomatoes are available (supply). What's the price? Answer: anything or nothing (nonuniqueness). Even better, Osborne shows that one can obtain data on both supply and demand as a function of price, so that discrete (noncontinuous) supply and demand curves can be plotted for a given commodity in a given market. What a pity that Osborne did not set his mind to discussing 'utility', because (as Mirowski points out in "More heat than light) the differential form that defines utility is generally nonintegrable, meaning that utility dooes not exist. Samuelson wrote papers trying to get around this in the 50's, but the correct underpinning of General Equilibrium Theory was never established. Osborne rightfully points out that people who believe in the approximation of continous price changes and efficient markets are grist for the mill of traders who use just the opposite assumptions to make money off them every day.

I wish that economics students would be required to read Osborne and Mirowski, but that isn't likely to happen. Meanwhile, the Fed keeps hiring those guys to crunch questionable numbers using the CAPM and similar stuff.