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A Short, Sharp Shock

I've been glued to Bloomberg & CNBC for the past few days watching U.S. post-mortems on the "technical correction" of the subprime mortgage market. This has been a "guilty pleasure" since reading George Soros's "reflexivity" theory a decade ago, and more recently following the Capital Markets CRC.

Capital markets' role --- particularly the new "actors" such as currency speculators and risk arbitrageurs --- is one dividing line between the worldviews of "pragmatic" and "critical" futurists. Susan Strange's description of capital markets as a "casino economy" and Ulrich Beck's "world risk society" (Masters essay PDF) appeal to "critical" school exponents.

This description misses the "excluded middle" that many risk arbitrageurs in the Vaeshya caste use "critical" school theories for "pragmatic" ends.

Baseline Case: Hedge funds used to hire PPEs: Oxford, Cambridge & University of Chicago graduates with knowledge of Economics, Politics and the broad horizons of Philosophy (usually either logical positivist, social constructivist or constructivism) for flexible thinking.

Anomalies Case I: Renaissance Technologies' hedge fund maven James Simons who taps string theory in quantum physics to build his risk arbitrage models, whilst remaining as enigmatic as Ayn Rand's hero John Galt.

Anomalies Case II: The widespread failure of "quant" models and strategies for hedge funds to halt or forecast the "technical correction" due to volatility in the U.S. subprime mortgage market. The "technical correction" may benefit author Nassim Nicholas Taleb --- a "contrarian" arbitrageur who has several books --- Fooled By Randonmess (2006) and The Black Swan (2007) on risk, volatility and wild cards.

Analogical Thinking: Bloomberg & CNBC media pundits have been comparing the subprime "technical correction" to the 1998 collapse of the prestigious hedge fund Long-Term Capital Management (LTCM). This is a case of "analogical thinking" much like how the 2003 Iraq War is compared to the U.S. "quagmire" during the Vietnam War. However it's a misleading analogy for several reasons: LTCM was a special case; the subprime case is hardly similar in effects or scale; and central banks in the U.S., Europe, Australia & Japan have moved to inject liquidity into the capital markets. The prevailing explanation of LTCM's failure --- a Perfect Storm outcome of the 1998 Russian lending default, financial contagion and moral risk --- ignore LTCM's internal culture, assumptions in the Black-Scholes model for options pricing, and the fact that Goldman Sachs and other firms were using similar hedging strategies. You can read more of my LTCM post-mortem in a Masters essay PDF.


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