Dynamics of Markets : Econophysics and Finance

Rating:
Summary: McCauley complements Keynes and Mandelbrot
Review: McCauley's(M) book definitely should be in the library of any technically trained (BA or BS degree in mathematics or statistics and a BA or BS in economics or finance) reader who is aware of the constant failure of neoclassical economics(and its modern variates such as rational expectations,real business cycle theory,monetarism,or supplyside economics), econometrics(Tinbergen,Frisch,Haavelmo and ,unfortunately,"Keynesian"econometricians like Modigliani,Tobin,Klein,and Solow) and financial analysts(Fama,Black,Merton,Scholes,Sharpe,Osborne,Markowitz and Cootner)to explain and forecast turning points in the business cycles of various countries and/or turning points in various financial markets(stock,commodity,real estate,currency,bond,money or derivatives)at any time in the last century,at least,using the assumption of normality(normal,lognormal,bivariate normal,multivariate normal,approximately normal,etc.).M presents a stochastic model based on the application of Green's Theorem to predict the future values of different options contracts(pp.180-192)that avoids the incorrect assumption of normality.M emphasizes changes in returns,as opposed to changes in prices a la Mandelbrot(pp.73-75).Again, the incorrect assumption of normality is avoided.This reviewer views these developments as occurring within the framework established by Mandelbrot no later than 1966.M is developing and improving aspects of Mandelbrot's general approach.However,there are three areas of M's book that need to be revised in a future edition.The first is his analysis of the classical-neoclassical concept of equilibrium and the process of adjustment involved over time.The argument made by neoclassical economists is that the economy( and all markets)is self equilibrating and always tending to or converging toward the optimal equilibrium point,although in point of fact,due to a constant set of external shocks,this equilibrium position is never reached.Thus, all short-run transactions may or may not be made at disequilibrium prices with no recontracting possible.The result,in the short run,is non optimal.However, in the long run,all of the losses and/or gains from such disequilibrium positions cancel or average out so that the resulting process can be analyzed "as if" the different markets were actually attaining equilibriums.Of course,all changes in market prices are assumed to be normally distributed around the equilibrium,market clearing price which is the average(arithmetic mean)of a normal probability distribution.This argument also is incorrect,but is much more difficult to refute since it is much more sophisticated ,using(misusing)the law of large numbers and the central limit theorem without ever actually examining the basic data.M needs to fine tune his basically sound critique to deal with the more sophisticated version of the neoclassical argument.If he does not,the neoclassical response will be that he does not understand microeconomic price theory.Second, Mandelbrot should not be bracketed with the likes of Markowitz Osborne,Sharpe,Black,Scholes,Merton,etc., on p.4 .Mandelbrot has, in fact,been clearly opposed,since the early 1960's, to the type of theoretical and statistical analysis and result that has been published by this group of economists and financial analysts.Third,M appears to have never read Keynes's A Treatise on Probability(1921;TP) or the 1939-40 exchange between Tinbergen and Keynes over the logical foundations of the basic econometric technique of multiple regression and correlation analysis ,as it regards forecasting of the business cycle.Keynes's complete argument can be found in chapter 17,pp.205-214,and chapters 29,30, 32,and 33 of the TP.Keynes always argued that,outside of the fields of life and physical science,the normal distribution was rather special and limited in application. The use of it required clearcut empirical testing of the data before normality could be assumed.Finally,Keynes's analytic tool in the General Theory(1936) is to show that the general case in macroeconomics is the existence of multiple stable equiibria.This describes the commodity or output market.The labor market is a function of changes in the commodity market.The labor market is in a state of constant disequilibrium,equilibrium only possibly occurring in the special case of a global optimum being obtained in the commodity market.M is correct that the analysis in most markets should be based on excess demand functions.Keynes arrived at this approach in 1936.A set of D=Z functions(functions clearly defined by Keynes in the GT and analyzed by Keynes in chapters 20 and 21 of the GT) define a locus of points that Keynes called the AGGREGATE SUPPLY CURVE.Only one of these points gives a global optimum.The economics profession has made a bloody mess of Keynes's mathematical analysis since the publication of the GT in 1936,constantly confusing the expected aggregate supply function,Z,with the aggregate supply curve,D=Z.M's treatment of Keynes is deficient and needs to be fixed in a later edition.A complete mathematical analysis of Keynes's theory of effective demand is contained in Brady(2004),"Essays on JM Keynes and..."

Rating:
Summary: Dynamics of Markets - Econophysics and Finance
Review: Dynamics of Markets - Econophysics and Finance

by Joseph McCauley

reviewed by: Enrico Scalas

In 1720, Newton invested his money in the South Sea bubble and lost £20000, a lot of money in those days [1].
So, physicists do not always do it better in financial markets.

Having said that, let us now go on and consider the merits and limits of this book by Joseph McCauley.

The book is divided into nine chapters. Chapters 1, 3, 8 and 9 cover material from epistemology (ch. 1), probability theory (ch. 3), fluid dynamics (ch. 8), and the theory of computation (ch. 9). Chapters 2, 4, 5,6 and 7 are mainly devoted to economics and finance. Namely, chapter 2 critically reviews the general theory of equilibrium, chapter 4 is on the dynamics of markets, chapter 5 and 6 present portfolio selection theory and
option pricing, respectively, and, finally, chapter 7 is a criticism of thermodynamic analogies in finance.

The range of interests of the author is overwhelming and this book is the first attempt to put together many concepts taken from various disciplines in a coordinate view. I am a fan of this method and I much appreciate the effort of the author. However, this is also a limit, as the reader looking for recipes to price options or to select a suitable portfolio will be somehow disappointed. In the very same way, those looking for a
rational criticism of neo-classical assumptions in economics are likely to read the chapters on option pricing without great passion.

In a short review, it is impossible to take into account all the aspects of McCauley's book.
I will just discuss one: equilibrium in economics. But, before that, let me underline that this is the first book in Econophysics where everything in finance is done by explicitly formulating and calculating Green functions. Second, the author presents the European option price predictions in a closed algebraic form and, third, Gaussian returns play no role in the predictions fully based on the empirical distribution.

The author presents a nice criticism of the concept of equilibrium in economics which, in itself, is worth
buying and reading the book. The arguments are scattered throughout the book, as the author is interested
in discussing the behaviour of financial market. For economics and finance, the author provides convincing evidence that the only legitimate form of equilibrium is vanishing excess demand. But price fluctuations in actual financial markets cannot be effectively explained by a sequence of different economic equilibria determined by varying exogenous factors. Then, the only possibility is that excess demand is considered as a stochastic process leading to diffusive models for price (or return) dynamics. Thus, the use of the Green-function formalism in Finance is a natural and logical choice.

McCauley's discussion on equilibrium would have been helped by reference to Kaldor's 1972 paper on the irrelevance of equilibrium economics [2]. Kaldor's point of view coincides with the one of McCauley when he argues that ultimately theories must be confronted with the real world. In discussing the difference between an axiomatic theorem and a scientific theory, Kaldor quotes Einstein: << Physics constitute a logical system of thought which is in a state of evolution, whose basis cannot be distilled, as it were, from experience by an inductive
method, but can only be arrived at by free invention. The justification (truth content) of the system rests in the verification of the derived propositions by sense experiences. The skeptic will say: "it may well be true that this system of equations is reasonable from a logical standpoint. But it does not prove that it corresponds to nature". You are right, dear skeptic. Experience alone can decide on truth. >> [3]

Also in this book, as in many contemporary books, there are various misprints and the constant reference to wrong equation numbers is disturbing.

I think that this book can be read with profit both by physicists interested in complex systems and by economists interested in the principles of their discipline. Economists can always refer to Newton's example mentioned above, when they read in the book about the success of physicists in finance.

References

[1] C. Reed, "The Damn'd South Sea" Britain's greatest financial speculation and its unhappy ending, documented in a rich Harvard collection. Harvard Magazine, May-June 1999.

[2] N. Kaldor, "The Irrelevance of Equilibrium Economics", The Economic Journal, vol. 82, n. 328, 1237-1255, 1972.

[3] A. Einstein, "Ideas and Opinions", Gramercy; Reprint edition (December 12, 1988).

Rating:
Summary: Frustrating
Review: I found reading this book extremely frustrating. The author spends a great deal of time telling the reader how all economists are ignorant morons and how physicists are the only ones capable of tackling such a problem. True or not, I dont really care. I wanted to read about complexity and chaos theory in finance, and unfortunately I had to battle though muddled explainations of economic theory to get to anything worthwhile. I would not recommend that you buy this book as only about 50 pages are really worth reading - maybe get it out of the library. and i certainly wouldnt recommend it to anyone other than a physicist.

Rating:
Summary: A new kind of finance
Review: Neo-classical economic theory is not a good approximation of real markets, as many have argued in the past and more insistently in the last decade. Very rarely, on the other hand, criticisms are so accurately motivated as in this book. In fact the author uncovers both theoretical and empirical inconsistencies of standard economics tex-books, showing the reader a path towards a re-foundation of finance theory. A new model of option pricing, based on the empirical distribution of returns, is proposed therein. After a brief introduction to the mathematics involved, the book presents, for each subject treated, the standard economic approach and a different point of view. It then falsifies the former and illustrates the latter with clear examples: an effective pedagogical procedure.

In the first part the main ideas of the dominant microeconomic theory, which assumes stable global equilibrium, are reviewed critically. Physicists learn that the quest for a global solution of nonlinear systems of equations is very rarely successful. Nevertheless it is widely believed that global deregulation leads to an efficient market, the mythical stable optimum theorized by neo-classical economics. Standard finance theory is introduced in the core of the book. The author's precise criticisms hit the often misused notion of equilibrium and the Modigliani-Miller theorem. This states that a firm's market price is independent from its debt-to-equity ratio, whereas Enron' s collapse seems to provide evidence of the opposite. Special attention is devoted to portfolio selection theories and to the Black-Scholes equation for pricing options in particular. Then the author illustrates his empirically based theory of market dynamics, which is a markovian stochastic process where the diffusion coefficient is not constant. Options can be priced accordingly, using the empirical distribution of returns -instead of the Gaussian one. The last part of the book discusses other applications of the physics of complex systems to finance. The author argues that thermodynamic analogies fail in economics, describing the example of a hedging strategy. Scaling and correlations are also treated in this part, before a brief review of the main conclusions drawn by various physicists who analyzed financial data.

The author guides readers of any level through the chapters they could be interested in and provides them with an accurate bibliography. But this book is not only a useful contribution to econophysics and finance theory. Especially after American elections, neo-libaral policies are going to receive a strong support from the Bush administration. McCauley demonstrates that their claims are not at all supported by empirical evidence nor by scientific rigor. amazon

Rating:
Summary: From Economics to Econophysics
Review: Prof. McCauley's book deals with the dynamics of markets in a new and elegant way. This book challenges the economist's description of financial markets. The market model discussed in the book correctly models the empirical data. The part of the book which deals with "what we learn from ENRON" should be appreciated by a much wider audience.

Rating:
Summary: Some strengths, some weaknesses
Review: The book serves up a very interesting and enlightening alternative to traditional economic thought in a variety of different contexts. I would certainly recommend it to any graduate student of physics or economics seeking to have a well rounded view the financial world.

The great weakness of this text is that the author seems to more than simply disagree with traditional economic theory, he despises it. That might not by itself be so great a weakness if the theory offered up in its stead were compelling, but, the author's passion notwithstanding, that is not the case here. The math aside, in tone and method this book reminds me very much of books authored by Intelligent Design advocates, seeking more to destroy the prominent competing theory than to present a coherent theory of its own.

Perhaps such passion is needed to get the neoclassical economists to pay attention. As in many things, I suspect the two schools of thought have much to teach one another.

On a more practical level, this is not a book for those who have not had a very solid grounding in mathematics, and likely unsuitable for all but the brightest, and most mathematically inclined, undergraduates.

Rating:
Summary: Rewriting Finance
Review: This book shows that the new discipline Econophysics finally comes of age, of which Joe McCauley is a main player. Until recently most the published work is accesibe to a small number of so-called econo-physicists, and it only adds some so-called improvement on the existent finance theory. This new book gives a coherent account of what might one day a new finance theory. While it is generally recognised that the main stream Economics, which incorporates Finance, since long in serious crises. It's not so much as the standard theory is wrong, as it is irrelevant judged by the practitioners. In the recent best seller (Alchemy of Finance) Soros said "...the fact that I can get by without even knowing the current theory speaks for itself...".

There are some recent papers from econophysics, as well as from well known economists (not in the main stream though), like Thaler of Chicago, Brian Arthur of Santa Fe, R. Shiller of Yale, Mcffaden of Berkeley (Nobel 2000) have pointed to fundamental overhaul of the standard theory. The book proposed by McCauley will be a timely contribution, the scheme outlined is a clear demonstration that without all the wrong, irrelevant assumptions the Finance theory would only look more sound and natural.

Note also that the author has spent last a few years doing active research and discovered some surprising results about option pricing. A more pedagogical, coherent volume is indeed welcome.

It's likely that traditional finance economists from the Establishment would put up a fierce fight, if their opinion is solicited.

After all, no one has the pleasure to see outsiders transgress on his turf. But, economists have squandered their chance for so many years and revolution is unlikely coming within.