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F.A.Z.-Column by Emanuel Derman : Espequanto for Beginners

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Benefit by sprinkling your daily conversation with terms from finance, even when talking about love or sports or food. This is an introduction to the the art of talking quant.

          4 Min.

          Want to impress oligarchs and their beautiful companions this Christmas at Courchevel? Or perhaps you simply need to sound like a Wall Street master or mistress of the universe at your weekly golf game or book club? Whatever your gender, you can only benefit by sprinkling your daily conversation with terms from finance, even when talking about love or sports or food. This is an introduction to the the art of talking quant.

          Espequanto isn’t a new language, though like all live languages it constantly changes. Schopenhauer used it more than 150 years ago, comparing our unavoidable and unexplained need for nightly sleep to the regular payment of interest on a loan. „Sleep,“ he wrote, „Is the interest we have to pay on the capital which is called in at death; and the higher the rate of interest and the more regularly it is paid, the further the date of redemption is postponed.“

          You can rate Schopenhauer AAA for doing so well with the limited financial material he had -- mundane unexciting loans. Since then the financial world has spun off tons more complex financial instruments and a corresponding quant terminology to go with them. A sophomoric male trader can now say perfectly understandable things like: „She’s got a really non-normal distribution, but I’m so far out of the money there’s no chance I’ll ever hit her barrier.“ With a little work you can get to that point too, though it may take more than one lesson. Meanwhile, let’s begin. You can’t use metaphors until you know their foundation.

          Why it is so unreliable

          Investments in securities or more personal endeavors have one thing in common: their outcome is uncertain. The quintessential question of financial theory is „What return should I (hope to) get for taking on a given amount of risk?“ Isn’t that the essential question of life too?

          Someone once quipped that in physics you have 3 laws that explain 99% of phenomena, but in finance you have 99 laws that explain 3%. It’s a good joke, correct in spirit, but it’s inaccurate. There is only one principle that more or less works in the theory of finance, and it can be simply stated:

          You can never get a totally free lunch.

          What this means is that for every potential upside to an investment, there must be a downside too. If you can potentially profit, you must be able to potentially lose too.

          From this principle you can derive almost everything a quant needs to know. But it’s only a principle, not a law of nature. That’s why finance and economics is so unreliable -- its principles don’t actually hold. Free lunches abound -- bank bailouts, crony capitalism, privatization, advancement by corruption, etc.

          Alpha and Beta

          You can always earn a more or less riskless return by lending money to the Treasury of some apparently solid country like the USA or Germany. You give them $ 100 or € 100 and they will (promise to) pay you some interest and repay your principal in one year, pretty much no matter what happens short of an asteroid striking the earth. These days they pay you just about 0% interest, thanks to the policies of „free-market“ central banks who manipulate interest rates for a living.

          The first major insight of financial theory is that if you hope to earn more than 0% you have to take some risk. Rather than lend money to the government, you could buy the stock of Deutsche Bank for example, and hope to earn more, say 10% over the next year. But anything can happen and so Deutsche Bank’s returns will be volatile, fluctuating from year to year. In any given year it might gain as much as 30% or lose as much as 10%, varying by 20% about the average.

          A key consequence of the no-free-lunch principle I will state without proof is that if returns are volatile you can prove that you should expect more return from riskier stocks. Quants express this as an equation: or, in words more return comes from proportionately more risk.

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