CFA Institute

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovationby Richard BookstaberReview by: Martin S. FridsonFinancial Analysts Journal, Vol. 64, No. 2 (Mar. - Apr., 2008), pp. 94-95Published by: CFA InstituteStable URL: http://www.jstor.org/stable/40390118 .

Accessed: 15/06/2014 10:01

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact support@jstor.org.

.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial AnalystsJournal.

http://www.jstor.org

This content downloaded from 195.34.79.176 on Sun, 15 Jun 2014 10:01:18 AMAll use subject to JSTOR Terms and Conditions

Financial Analysts Journal

Although survivorship and selection bias cannot explain the entire equity premium puzzle, this aspect of the authors' research has important impli- cations beyond the equity premium topic.

The section on predicting variations in the equity risk premium indicates that little progress has been made, despite extensive work on the problem. For example, contrary to the results of others who have studied the question, Goetzmann and Ibbotson suggest that dividend yield may not be a good predictor of future premiums. Data lim- itations cause the findings on this critical topic to be confusing.

Books of essays are generally problematic. The quality of the work is invariably uneven and sub- ject to redundancies. Some research is simply out- dated and not useful for most readers in its original form. A major disappointment of The Equity Risk Premium: Essays and Explorations is the limited review of research by others, several of whom have

made significant contributions. Goetzmann and Ibbotson cite many other works, and several of the papers in this volume have coauthors, but this book does not constitute a complete review of the equity risk premium puzzle.

Given the quality of the authors' previous work, I expected a deeper interpretation of the overall puzzle of the equity premium than the short introduction this book provides. The book's focus is on empirical issues at the expense of theoretical explanations of the equity risk premium. Many excellent researchers have offered innovative explanations of the puzzle, and a Goetzmann- Ibbotson critique of these results would have been insightful. Nevertheless, The Equity Risk Premium is a useful addition to the literature, partly because few alternatives for obtaining information on the topic are available in one book.1

- M.S.R.

Notes 1. An exception that is short and highly readable is The

Equity Risk Premium: The Long-Run Future of the Stock Market by Bradford Cornell (John Wiley & Sons). Its 1999 publication date, however, means that it does not incor- porate the most recent research on the topic. Another

significant source of empirical work, although it does not address the explanation of the equity premium puzzle, is Triumph of the Optimists: 101 Years of Global Investment Returns by Elroy Dimson, Paul Marsh, and Mike Staunton (Princeton University Press, 2002).

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation. 2007. By Richard Bookstaber. John Wiley & Sons, Inc., +1 (201) 748-601 1 , www.wiley.com. 276 pages, $27.95. Reviewed by Martin S. Fridson, CFA.

Richard Bookstaber proudly proclaims that, although he did not personally cause the 1987 stock market crash and the Long-Term Capital Manage- ment crisis of 1998, he "was definitely one of the guys fiddling with the controls." He certainly had the requisite experience and expertise for it. His long career in finance has included stints in research, risk management, and proprietary trading at prominent investment banks and hedge funds. The product of that experience, the masterful A Demon of Our Own Design: Markets, Hedge Funds, and

the Perils of Financial Innovation, gives readers a front-row seat - complete with candid sketches of many key players - at some of the most momentous financial events of the past two decades.

Bookstaber was part of a mass migration of academics to the practitioner ranks in the 1980s. As a graduate student at MIT, he became fascinated with the application of advanced quantitative tech- niques to economics. Pioneers of that approach confidently acted on the premise that consumers and producers could be modeled in the way that physicists model planets and subatomic particles. Bookstaber's readers will benefit from following the intellectual journey that has left him wary of injudiciously applying such methods. A recurring pattern in the book involves a financial model that works extraordinarily well - until it blows up as a consequence of effects that the modelers omitted.

Drawing on his expertise in sophisticated instruments, Bookstaber has produced the clearest explanation so far of the past several years' finan- cial markets derailments. Happily for readers, he is adept at explaining highly technical transactions in accessible prose.

Martin S. Fridson, CFA, is CEO of FridsonVision LLC, New York City. Book Review Editor's Note: I worked with Richard Book- staber in Morgan Stanley's Fixed Income Research Department in the mid-1980s, and we have remained friendly in the intervening years.

94 'www.cfapubs.org ©2008, CFA Institute

This content downloaded from 195.34.79.176 on Sun, 15 Jun 2014 10:01:18 AMAll use subject to JSTOR Terms and Conditions

Book Reviews

To underscore his points, Bookstaber draws analogies from a formidable range of interests, including the ecosystem of Lake Victoria, landown- ership in medieval England, and Brazilian jiujutsu. These parallels are not mere digressions. For exam- ple, he describes how Southeast Asian monkey trappers place a lychee nut inside a box with a hole just large enough for the monkey's hand:

All the monkey has to do to free its hand is let go of the lychee, because the hole is too small for the monkey's hand if it is clinched around the nut. The monkey refuses to surrender its prize and

is captured, providing an apt image of traders' sometimes disastrous unwillingness to give up on their bad positions.

To his further credit, Bookstaber accurately recounts two historical incidents that are fre- quently misrepresented in the literature, namely, the 17th-century Dutch tulip bulb speculation and Nathan Rothschild's actions following the Battle of Waterloo.

Inevitably, minor errors creep into the text. For example, there was no Louis Bernard in Mor- gan Stanley's senior management in the 1980s, although Lewis Bernard headed finance, adminis- tration, and operations.

Also, Bookstaber attaches the phrase "circling vultures" to his account of Citigroup senior man- agement's plan to shut down the troubled arbi- trage group that it acquired with its purchase of Salomon Brothers. This metaphor perpetuates a myth about vultures' behavior toward expiring animals. Their circular flight has more to do with the challenge of gaining altitude with their wings in a V-shaped configuration.

These small imperfections should not distract readers from the important question that A Demon of Our Own Design addresses: Why are financial markets becoming more prone to crises even though the underlying economy has grown less risky over time? Bookstaber argues that innovation has contributed to the instability of security prices. Although helpfully speeding up the flow of infor- mation, advances in technology and financial engi- neering also add complexity that multiplies the opportunities for system failure.

Bookstaber not only documents the problem but also proposes a solution:

I believe the markets can better conquer their endogenous risks if we do not include every financial instrument that can be dreamed up, and take the time to gain experience with the standard instruments we already have. Just because you can turn some cash flow into a tradable asset doesn't mean you should; just because you can create a swap or forward con- tract to trade on some state variable doesn't mean it makes sense to do so. How "we" can be induced to refrain from exces-

sive innovation is left unexplained. Who is the potential Czar of Innovation wise enough to deter- mine which ideas ought to be discarded? How could global financial firms, which earn their highest mar- gins on new products, be compelled to accept such an arbiter's directives? The markets' frenetic inno- vating cannot as easily be brought to heel as Book- staber implies, but even so, his book is essential reading for practitioners and policymakers hoping to gain an understanding of contemporary finance.

- M.S.F.

March/April 2008 www.cfapubs.org 95

This content downloaded from 195.34.79.176 on Sun, 15 Jun 2014 10:01:18 AMAll use subject to JSTOR Terms and Conditions