Finance Watch

Global finance must be reined in order to fight climate change

Arbitrage theory
Reading Level: Expert
Reading Time: 9 MIN.
Finance Watch

Photo by Markus Spiske on Unsplash

0

Reading notes from Nicolas Bouleau, “Le mensonge de la finance – Les mathématiques, le signal-prix et la planète“, Editions de l’Atelier, Feb 2018, 224 p. (only available in French, unfortunately!)

Foreword

Today’s world is governed by financial markets, and by the maths that rule over them. They are opaque to the vast majority of people – the average citizen, the elected, and most intellectuals. Most economists use only relatively simple models, and do not have a clue about the maths of finance. Therefore, financial experts quietly rule the world, not bothered by any unwanted outside scrutiny. From a democracy and “citizen empowerment” angle, this is unacceptable. Luckily, Nicolas Bouleau comes in. Mr Bouleau is an eminent French mathematician, who specialized in financial mathematics for the past forty years. He deserves our confidence. Throughout the book, he delivers simple images that enable ordinary people like us to get a glimpse of how mathematics are used in finance, and the huge consequences this has.

Activists have long campaigned against the damage done by speculative trading on global financial markets – they describe an amoral and reckless race for returns, its role in spurring instability, short termism, mass unemployment and growing inequalities. But nothing changes. By giving an inside view on the heart of today’s global financial markets, this book gives new and deeper hints on what global financial markets really do to our economy. And proposes a new, radical solution, to stop their destructive influence.

1. Only the volatility, NOT underlying asset price trends, determines prices on global financial markets

Let us consider a given currency, that we can buy today at the price of 10: let’s call it the underlying asset. Let’s also consider a call (the derivative product), i.e. a contract sold by a bank, according to which we have the right, but not the obligation, to purchase that same currency at the price of 15 in three months’ time. Intuition tells us that the price of this call will increase with the currency price. However, it is not so. Here comes the mathematical theory of arbitrage. It demonstrates that the call price is not related to the price of the underlying currency, but only to its agitation, to its restlessness, which is called volatility. This result applies to any kind of derivative product.

The arbitrage theory

The arbitrage theory is the mathematical basis for modelling financial trading. It appeared in the 1970s. It is central to understanding the structure of global financial markets but does not explain all their features: just as gravitation theory is central to understanding the structure of the Universe but will not explain why Saturn has rings. According to the arbitrage theory, the price of an asset traded on an organised market can be split into two components: the “martingale” and the “trend”. The “martingale” is the random price component, which varies erratically. The “trend” is the component that can be attributed to a more regular evolution over time. The arbitrage theory computes a “fair price” for derivative products, which is such that no riskless gain can be made from trading; at the “fair price”, there are no certain profits. The central result of the arbitrage theory is that the “fair price” does not depend upon the price trend, but instead only upon the “martingale”, i.e. upon the volatility. In other words, since the arbitrage theory is used on the financial derivatives markets, the volatility creates such a large agitation in prices that the underlying asset price trend is immaterial in comparison.

The more trade, the better the theory works

Organized markets are all the better described by the arbitrage theory as trading becomes more sophisticated. This stems from the very structure of the theory, which describes a world where there can be no riskless gain. The theory describes a market which is saturated with trading and creates the conditions for trading to always keep refining further. This is because the theory makes it possible to spot those prices that would create riskless gain opportunities. When this happens, all traders, since they use the same theory, will jump on such opportunities: relative prices will adjust, and the riskless opportunities for gain will become slimmer, and then disappear.

More and more sophisticated trading tools

Since the 1980s, IT has considerably increased the level of sophistication of trading activities. Let’s mention HFT, big data, artificial intelligence. Trading used to be an individual, intuitive business. It has become a highly professional business, reserved to those with huge means and capabilities. The race to identify arbitrage opportunities changes the price structures and conforms them more and more to what the theory says. A good trader knows that the usual trading techniques have already been tried and are therefore unlikely to yield much gain. He bets on his own spotting and stock-taking abilities to try and see what other traders fail to see.

The ever more sophisticated trading systems make gains increasingly out of reach for the average people. If we replace “trader” by “fisherman” and “trading” by “fishing”, we could say that today’s fishing is done using sonars and radars, and that one is ever more unlikely to catch fish with a simple rod.

Volatility, a thick smoke produced by the economic system’s engine

However, the arbitrage theory cannot forecast prices, because it cannot forecast the time when crises will occur, nor, for example, the price policy that price setters such as OPEC will adopt. The arbitrage theory tells but one thing: prices can follow any kind of trajectory, but this trajectory will be subject to volatility. Volatility is not an explanation for the market’s agitation: it measures it. It can be compared to a pollution, a thick smoke produced by the big engines that are ruling over the economy.

No asset price will follow a nice smooth curve, because this trend would immediately generate market movements to correct it. So, asset price movements are more likely to follow the shape of a steep mountain curve. Or, to take another image, the erratic movement of a garden hose when you hold it too far from the tip (the “random hose”).

The key role of trading in the making of asset prices

There are two kinds of markets for goods and products. The first kind are traditional markets, as theorized by Marx, Say, etc…, which can be called “socially allocated”. Each good, each seller, each buyer and each contract have specific, individual characteristics. Examples are the job market and the real estate market. Deals take time, and any trading activity needs to take into account the specific individual characteristics of each good.

The second kind of markets can be called “socially traded”. Goods and contracts are standardized, deals are fluid and fast. Examples of such markets are currencies markets, securities and commodities markets. Trading occurs on those markets and plays a key role in determining the trading prices of goods. And those prices have a huge impact on the economy as a whole: all corporate businesses see their purchase prices impacted by commodity prices, all agri businesses also see their sales prices impacted, through wholesalers who are « making the prices ».

In order to progress towards “market completeness”, free trade wants to transform the first kind of markets into markets of the second kind.

Efficient markets, an intellectual deceit, a fraud of finance

Eugene Fama, who was awarded the “Nobel” economic prize in 2013, named “efficient” the markets that are described by the arbitrage theory, i.e. markets where profitable trading is highly difficult, and where there are no riskless gain opportunities. We have seen, however, that in such markets, the volatility of prices will be at its maximum. By naming such markets “efficient”, Fama is implicitly hiding, denying, the very existence of volatility. It is similar to calling “healthy” those individuals who spend the most on health, who pay the maximum in diagnoses and treatments: in fact, the most seriously ill will fall into this category! And for the many economists who understand “efficient” as a legitimation of the application of free market principles, those principles are thus connected to the most evolved part of the maths used in economics. Changing the meaning of words is institutional violence and attacks the very core of scientific knowledge.

2. Today’s financial markets do not produce prices that facilitate trade: they shake prices up, hide price trends under the thick smoke of volatility, and sell derivatives to help see through it

The volatility hides price signals

Derivative products have not decreased the volatility on financial markets, quite the contrary. On currency, stock and commodities markets, volatility kept increasing since the 1970s, and the price of derivatives themselves is extremely volatile.

The financialized free trade economy produces prices which are erratic and volatile. Produced on global financial markets, those prices are hiding the underlying trends, which are however the most important and the most crucial information for the future. When data is highly volatile, one needs cumulative stock indicators to be able to see through a long-term effect. Meteorological data for instance is highly volatile, and one needs to look at the cumulative level of sand, or ice, or the cracks in the walls of a building over a long period of time, to be able to see the trend of what is going on.

Therefore, as far as human influence on the environment is concerned, any cumulative impact indicator can only be found away from market indicators. We need to build such environmental impact indicators using physical data measures, insulated from the overreaching influence of economics.

Corporate and governments’ economic decisions should not be based on prices influenced by global financial markets. They should rely on data such as GHG emissions, drinkable water reserves, food and rare metals stocks, biodiversity indicators.

The volatility is hiding scarcity

A common-sense idea, inspired by neoclassical economics, is that the depletion of natural resources will push prices up. Such increase in price would be beneficial, as it would decrease anthropic pressure on those resources. But this idea is wrong. Today, most physical resources are traded on global financial markets. On those markets, the price level follows three phases. The first phase can be called “adaptation”: businesses will use derivative products to hedge their supply: there will be volatility. Then the resource will start depleting. As uncertainty grows, volatility will increase, and the change in price will increase. Because of that uncertainty and volatility, the investment in alternative supplies or processes will be very slow, and it is not clear when the transition towards an alternative sourcing will be completed. Then the price collapses when the transition is complete and the resource is no longer necessary. In all three phases, it is impossible to detect a price trend: the depletion scarcity cannot be seen in any of the three phases.

The volatility prevents investment

Let’s consider a farmer facing investment choices for the years to come: he could plant more, build a warehouse, purchase equipment…The price at which he sells is imposed upon him by wholesalers, who are themselves referring to cargo prices determined on financial markets. The uncertainty is such that our farmer is incentivized not to invest.

Why do financial derivatives not produce a useful price signal? It is because, through the volatility, the uncertainty experienced by traders is imposed by financial markets onto all economic actors. This uncertainty is reflected in the high cost and volatility of derivative products. Food commodities derivatives, for instance, are no longer mainly used, since 2000, to hedge risks, but for market making (taking directional positions on the markets).

…3. Shielding the ecological transition from the blindness of mathematized financial markets

For all those reasons, we shall not achieve the ecological transition as long as global and mathematized financial markets will be blinding decision makers.

Our priority should be to rebuild an information and perception system based on the ecological and social state of the planet, using non-financial indicators, based on physical stocks. There is a new role there for the scientific community. Scientists are today the community which is the most common goods-oriented, the most prone to defend biodiversity, the most reticent to artificial hyper-productivity false solutions. Scientists are also first in line when it comes to worrying about the future, notably as climate change is unfolding. They must find with this a new basis for their message to society, and change from trumpeting unstoppable progress to bearing, more than others, the weight of the worries about the future, which they also understand the best.

Scientists must radically debunk all beliefs in a would-be natural harmony created by global financial markets. The institutions that rule today’s world (IMF, WTO, global financial institutions and think tanks), are spreading the dominance of finance not only in markets, this is done already, but also in the realm of values and beliefs, in people’s minds. Those institutions are short sighted and smoke-producing. They must be ring-fenced and their influence needs to be reduced. The idea of a World Organisation for the Transition (WOT) must be fought for, it must grow through local initiatives until it gets politically empowered by a citizen’s democratic consensus.

And science, untainted by selfish interests, should recover its capacity not just to think, but also to act, for the common good.

Mireille Martini

Make a comment
Finance Watch Friends newsletter

Friends newsletter