Financial Risk Management For Dummies. Aaron Brown

of people are in the job market – some have jobs, some don’t, some want jobs, some don’t; and a lot of people are in intermediate job states – employed part time, employed but looking for a new job, self-employed by choice or not by choice, student, retired and so on.

      Physicists and economists want to make statements about the aggregate values. Physicists want to say that increasing the pressure by shrinking the jar will increase the temperature. Economists want to say that increasing inflation by cutting interest rates will reduce unemployment. But how does an air molecule know what the aggregate pressure is, and how can it use that knowledge to increase temperature? Also, if air molecules aren’t the things that react to pressure to increase temperature, what is? For economists, how does the inflation rate that the Bureau of Labor Statistics is going to announce in six weeks affect whether or not an employer takes on an additional worker?

      The answer that physicists worked out at the end of the 19th century, and that risk managers came to appreciate about 80 years later, is that the macrostates like temperature or inflation rate are actually statistical statements about the likelihood of individual microstates, which are the motions of individual particles or the decisions of individual economic actors.

      Okay, that’s pretty technical. (I think it’s fascinating, but you’re free to disagree.) What’s important to understand in order to understand risk management is that this concept of likelihood and statistics is an entirely new way of thinking about risk. There’s nothing random about particle movements or the unemployment rate, yet to understand the properties of a jar of air or the properties of an economy, you have to treat the particle properties and unemployment rate as random variables.

      There is a difference between physics and finance. In finance, you typically talk about millions, or at most billions, of transactions. In physics, statistical thermodynamics is applied to systems with billions upon billions of particles or more. In physics, it’s entirely possible that a benign macrostate will, purely by random chance, select a microstate that puts all the air molecules in the same part of the jar, or at least enough of them to create a temperature and pressure that cracks the jar, thus changing the macrostate. However, so many particles exist that the chance of a measurable aberration from uniform temperature and pressure is negligible. In finance, you deal with systems small enough that these sorts of events are rare but do in fact occur from time to time.

      A major risk in the financial markets is that the random distribution of macro forces to individual transactions will align by chance in a way that disrupts the markets, which in turn disrupts the economy, which in turn delivers additional shocks to the market. If that happens, it may be months or years before any kind of equilibrium is restored.

Trading in uncertainty

      In the early 20th century, physicists discovered an entirely new kind of randomness, quantum uncertainty, that didn’t obey the rules of macroscopic probability. Subatomic particles behave randomly, but not like coin flips or dice throws, and not like Bayesian bets.

      When you flip a coin, the result is either heads or tails, it makes no difference if anyone looks at it or not. But in the quantum world, the coin is both heads and tails until someone checks to see which it is.

      An analogy putting you as the detective in a murder mystery may make this difference clearer: Before you know whodunit, you’re suspicious of everyone, and you’re uncertain about events because the testimony of the murderer is likely false. Given what you know so far, you think you have a 66 per cent chance the duke did it and a 34 per cent chance the butler did it. If you knew it was the duke, you would lock up the duke; if you knew it was the butler, you would lock up the butler; but given your uncertainty you lock up no one. You don’t lock the duke up 16 hours in the day and the butler 8 hours. The point is that the actions you take under uncertainty are not the weighted average of the actions you take under each of the possible resolutions. The state of uncertainty is fundamentally different from any of the possible resolved states.